Commercial Mortgage borrowers come in all levels of expertise from expert to novice. However, the successful borrowers have one thing in common.
Successful commercial borrowers understand that owning commercial real estate is a "business" and any loan against a commercial property is a "business loan".
To put this perspective, let us look at a "residential mortgage loan" as compared to a "commercial mortgage loan".
Given a well qualified residential mortgage borrower, the lender looks to the "income of the borrower" to support the loan.
Given a well qualified commercial mortgage borrower, the lender looks to the "income of property" to support the loan.
Taking this concept one step further, commercial real estate is normally regarded as a "business within a business" one that has to stand on its own, regardless of how successful the underlying business, or borrower, may be.
Simply put, any borrower's specific commercial real estate property being tendered for a loan, at any Loan to Value (LTV), must be generating enough cash flow to cover:
•· The property's normal operational expenses
•· The lender's mandatory reserves
•· The monthly principal and interest payments
•· Plus, additional cash flow profit to cover both Owners' and Lenders' investment risk
To sum up, the Lender, as a business/partner investor in the property, needs to feel comfortable enough to expect the property to continue performing profitably under the Lender's absentee management, if necessary.
Now let us put the above into practice so you, as a potential commercial borrower, can pre-analyze (underwrite) an example income property that we will pretend you may want to purchase.
Assume a 6 unit apartment building with each apartment renting at $910 per month. The seller is asking $500,000 and his tax returns show his real estate taxes for the property are $10,000 per year, insurance is $3,500 per year and common utilities are $1,450 per year, including yard care, as each unit pays its own utilities. Your lender requires a 20% down payment.
You can do the following quick analysis by building a simple spreadsheet:
Gross rents are $65,520 --- or 6 apartments x $910 x 12 months.
Next we will reduce the Gross rents by 10% to cover the Lender's required reserves for Vacancy & Management to arrive at a Net Rent of $58,968
From the Net Rent, we will deduct the expenses reported on the owner's Tax Return for Real Estate Taxes, Insurance and Common Utilities which total $14,950
After the above subtraction, we arrive at what is called the Net Operating Income (NOI) of the property, which in this case is $44,018
To insure we are going to make a profit on our investment in the property, we now divide the NOI by 1.2 to arrive at the buyer's "Profit Adjusted NOI" of $36,682. This adjustment to the original NOI not only a builds in a profit for the buyer/investor ($44,018 - $36,683 equaling $7,336), but also adds a safety margin of extra cash flow to satisfy the Lender's aversion to risk.
Now dividing the Profit Adjusted NOI by 12 will give us the monthly Principal and Interest (P & I) payment that this "Business Property" can support to be acceptable to an interested Lender. This division results in a proposed monthly P & I payment of $3,057
With the use of an on line mortgage calculator we can determine that $3,057 at an interest rate of say 8%, amortized over 30 years, equals a mortgage principal amount of about $399,797
Because the derived mortgage principal amount essentially equals the $400,000 needed to purchase this property at 80% LTV, if the buyer's credit, experience and liquidity is acceptable to the Lender, this property will most likely meet a Lender's requirements for funding at the asking price.
As a result of this simple analysis, not only does the buyer know he can obtain the needed commercial mortgage necessary to purchase his new investment property, he also knows that the property will provide him a $7,336 annual cash flow profit (ROI) per year or about 7.3% return on his invested cash.
Now let us assume the above property is a 6 unit "Office Complex" with the same asking price, income and expenses and with each unit consisting of 1,000 square feet of space.
Assume also that our borrower is a successful service business owner presently leasing 2,000 feet of space for $2,000 per month.
This borrower desires to build equity not only in his business, but also in commercial real estate as opposed to making his Landlord rich. Therefore he investigates purchasing the above Office Complex commercial property, as an Owner Occupier, planning for the property to be held in a separate LLC holding company that will lease two (2) of the units to his company (33%) while keep the remaining tenants on long term leases.
Looking at the above analysis, simple math tells us that this borrower can lower his company's monthly rent to $1,820 thus saving his operating company $2,160 per year in rent, while his LLC holding company makes $7,336 profit per year. In addition, his company's rent for two units, plus the rent of the remaining tenants, will continually build him increasing commercial property equity each month as the combined rents pay down the mortgage.
In truth, the above Investor and Owner Occupier scenarios are even more attractive than presented due to the tax advantages of commercial property ownership, but that is a subject for another time.
In summary, if you are a potential commercial property purchaser, either as an Investor or as an Owner Occupier, you now understand that any commercial property that you may desire to purchase must generate cash flow sufficiently to cover all expenses, reserves, the proposed P & I, ---- plus show a profit!
Grasping this simple concept, and utilizing it, will save you untold time and frustration, gain you advantageous leverage with Sellers and Lenders and ultimately take you to the promised land of owning a "profitable" commercial property portfolio.
By simply creating a small spreadsheet resembling the above analysis, you too can pre-analyze (underwrite) most commercial property deals like an expert!
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Arthur L Pepperman II's career in small to mid sized business consultancy, bank consulting, business and commercial real estate brokerage and professional business evaluating led to his creating CMS Funding. CMS Funding has recently become a Division of Commercial Capital Ltd, a virtual direct lender that has funded $100 million in commercial loans so far in 2008. Further business information can be found at http://cms-funding.com and http://commercialcapitalltd.com/cmsfunding
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