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Negotiate With a Lender: Commercial Property Loan

Commercial Real Estate Loan

Questions With a Lender for a Commercial Property Loan

A piece of property is considered to be commercial property when it is five units and above.  This includes apartments, office, retail, warehouse, mixed use and flex space.  A completely different lender and lending guidelines apply to these properties.  It is critical to your success to make sure that you are working with a lender that specializes in commercial loans.

Ask a Lender These Questions:

“What do they have an appetite for?”  This means what they are lending on in regards to the categories that are mentioned above.

“What is the commercial loan based on, the loan to value or the debt coverage ratio?”  It can be one or the other or it can be both.

“What are the terms that you are offering on commercial loans?” It could be 70% LTV for 25 yrs at 5% and a balloon in 10 yrs.  Or it could be a debt coverage ratio of 1.25 for 25 yrs at 5%.  These are two different kinds of loans.

For example, let’s say that you have a property that brings in a NOI of $2000 a month and the bank uses a 1.25 DCR.  The way that you determine the DCR is that you take the Net Operating Income and divide that by the DCR rate.  So, in our example, we have a $2000 NOI and we divide that by 1.25.  That gives us $1600 a month for Principle and Interest.  If you subtract the monthly payment from the NOI you have $400 a month in cash flow.  To determine your annual cash flow, simply multiply by 12.  This property has $4800 in cash flow for the year.

“What is the minimum credit score for this commercial piece of real estate?”  Usually the bank requires a credit score around 725, but keep in mind that each lender is different.

“What is the debt to income ratio?” Currently lenders are doing approximately 50% maximum debt to income ratio.  That means you are allowed to spend 50% of your income towards debt.  Debt is principal and interest.  Because of Dodd/Frank there is the possibility that the debt to income ratio may be lowered to 43% in the future.  Keep in mind that every bank, savings and loan, & credit union has their own loan conditions.

The sixth question you want to ask if you are looking at a loan which is based on debt coverage ratio is “What does the bank require in terms of vacancy rates?”

“What does the bank require in terms of a cash reserve?” Cash reserve can be based on a percentage of the rent. Cash reserve can be based on a dollar amount per unit.  Cash reserves are for capital improvements over the investment period that you are analyzing.  These numbers take into account cash reserve, utilities, and so forth and reduce the amount of money that you are making and that is called net operating income.

“How much money do you need to set aside for management?”  This is a critical number in determining your Net Operating Income.

Net Operating Income is determined when you take the Gross Rents and subtract:

  • The vacancy factor
  • The taxes and insurance
  • The cash reserve
  • The utilities
  • The maintenance
  • The management
  • And any additional expenses

Once you have subtracted all of these expenses, you have the Net Operating Income.

Cash on Cash Return

The next thing that you want to evaluate is your cash on cash return.  Take the annual cash flow of $4800 from the example above and divide that by the initial investment to determine how much cash on cash return you are making for that piece of commercial real estate.

So what does the initial investment entail?  The investment entails your down payment.  So let’s look at the payment again $1600 P&I for 25 yrs at 5%.  By using a financial calculator you can determine that the loan amount is $298,050.  So if the property is selling for $372,563 for example, that would mean you had to put down $74,507 or your investment.

Therefore, a $4800 Cash Flow divided by $74,513 yields a 6.4% cash on cash return.  That means at the end of the year you are making 6.4% more than what you invested.  In commercial real estate, you are looking for how much cash flow you are getting as part of your financial return.

The financial plan is to get the $74,513 down payment to invest in commercial real estate.  There are several ways to get the down payment for a commercial property.

Acquiring a Down Payment

One way is to buy houses below market value, like a short sale or a foreclosure, and then sell them at market value for a profit. You will typically have to do multiple deals to generate a large enough down payment for the commercial property.  Once you have enough money, then buy the commercial piece of real estate.

Another way to do it would be to buy a house at a discount, then fix the house up, then sell the house at market value. You may have to do multiple deals to generate enough money for the down payment.

A third way to accumulate that $74,513 is to buy houses in markets that are appreciating, then rent those houses, hold them for a few years until the value increases by that $74,513, then 1031 exchange into a commercial piece of real estate. You don’t have to 1031 the property. You can just sell it, take the money, and move the money into a commercial piece of real estate.

A fourth way would be to bring in investors for the $74,513 and then share the profit or make them an equity partner in that venture giving them a piece of the cash flow and/or appreciation and/or principal reduction and/or tax benefits.

Richard Maryanski and Erik Maryanski
Rich Dad Education Elite Trainers and Mentors

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Due Diligence for Income Producing Properties

Due Diligence for Income Producing Properties

Due Diligence for Income Producing Properties

Whether you are buying a single family house, multifamily buildings or commercial properties, the Due Diligence process is a necessary part of acquiring real estate.  Whether you’re managing them yourself or having someone else do it for you, you must take the time to research the property thoroughly.  When you do your due diligence, you must take into consideration all of the different aspects and requirements that come with this investment.  Keep in mind that if you don’t complete these extra steps, no one is going to do it for you.  Cavat Empeter (buyer beware).

Property Plan
It is essential to have your management team accompany you through the Due Diligence process. They should understand their target market regarding the quality of tenants, the renter’s lifestyles, competitor’s properties, the housing market conditions, and potential for increased value or income.  As you go through the property with them, discuss what your goals are and make sure that you both have the same end game in mind.

Physical Inspections
Physical inspection should be completed by a professional home inspector, a licensed contractor, an engineer or an architect. Due Diligence is the time to find out anything that is structurally right or wrong with the property.

Zoning
Go to your city building zoning department and make sure the building has proper building permits for the use stated in the purchase agreement as well as a certificate of occupancy or zoning compliance letters. Never assume a four unit building is approved for that use simply because it has four electric and four gas meters. Avoid illegal apartments. By investigating these avenues, it will give us a realistic perception of the buildings legal usage.

Local Codes
Be familiar with local laws regarding properties that are greater than two stories. This falls into what we call the multiple residence law (MRL). These laws govern buildings such as mixed use properties or multi family, where you might have commercial on the first floor and residential on the second and third floor.   There are very comprehensive sets of rules put in place to protect fire safety and entrances and exits.  Make sure that the units are in compliance with state and local laws.

Environmental
Anytime there is oil, hazards or waste, a Phase One Environmental Inspection is always recommended. This procedure will allow for any issues regarding environmental matters to be addressed.  These take a long time so you will want to make sure you give yourself enough time for the due diligence period.

Leases and Applications
Review all rent roles and records for all existing tenants. Verify that leases are signed by both the landlord and the tenant keeping the expiration of those leases in mind. Verify all security deposits with seller’s records. Make sure you get certified rent roles and estoppel certificates signed at closing as well.

Expenses
All maintenance contracts such as lawn, snow, elevator, pest, trash, security, and any other maintenance contracts should be verified. Gas, electric, sewer, water, cable and any other utility bills should be verified as well.

During the Property Management and Cash Flow training we spend a lot of time going over due diligence. We do this to prevent people from losing thousands of dollars in lawsuits when deals fall apart right before the closing. Due diligence is the time to renegotiate any issues that might occur during the inspection period regarding your purchase. In closing, understand everyone’s roles and deliver consistently each and every time.

Jim Aviza
Rich Dad Education Elite Training Property Management Course Instructor

Commercial Lease Terms for Due Diligence: Frequently Asked Questions

Commercial Lease Terms

Commercial Lease Terms

In a previous blog, I introduced Commercial Lease Terms for Due Diligence.  Based on that article I have had a few requests for more information.  The following are some of the most frequently asked questions after Due Diligence begins.

Tenant Improvement Allowance:

As a rule of thumb we give an allowance of about $5.00 a sq. ft. for cosmetic rehab or renewal incentive.  If you are bringing in a new tenant with a complete build-out, you may be looking at closer to $15.00 a sq. ft.  If you are purchasing a property with a TI be sure the work has been completed and paid for prior to the purchase or receive a credit from the seller for the liability.

Turnkey:

I believe this one causes confusion because I have seen it used in two very different ways.  Some real estate professionals will refer to a finished unit as a turnkey unit, meaning what you see is what you get.  No allowance for improvements just turn the key and use the space.  These types of units would have very little upfront expense for the landlord.  The other way Turnkey is used is to imply completely furnished or equipped as in all the tenant needs to do is walk in.  Clearly there is a wide spread in these operating costs so be sure to ask the necessary questions to determine your ongoing costs.

The next few items are numbers the lender will review.

Expense Ratio:

This is the percentage of expenses to the Effective Gross Rent (EGR).  When you are analyzing Office, Retail, and Industrial there will be variations based on the tenant expense reimbursement for Net, Net Net or Triple Net Lease.  While apartments still have some variations, you can assume that any expense ratio under 30% may be suspect to a lender.  A newer building may have an expense ratio of 30 to 35%, but most apartments will be 40 to 45%.  In order to stay on top of current trends and variables, you may want to investigate the National Association of Realtors reports “Income and Expense Ratio – Apartments” and “Income and Expense Ratio – Office.”

Difference between Initial Capital Improvements and Reserves for Capital Improvement:

The Initial Capital Improvements are items that you will do within the first 12 to 18 months of ownership to improve or repair the asset.  Often the lender will want to see this money in a reserve account prior to approving the loan.

Reserves for Capital Improvement are funds you are setting aside to insure the ongoing integrity of the asset.

Initial Capital Improvements will depend on the current condition of the property however the following are guidelines for a few commercial products.

Capital Expense Reserves:

  • Apartments: $300 per unit per year
  • Retail:  between 3-5% of Effective Gross Rent
  • Office: between 3-5% of Effective Gross Rent
  • Industrial: between 2-4% of Effective Gross Rent

*A conduit loan may be .15 per sq. ft. per year for Office and Industrial

  • Self-Storage: between 3-5% of Effective Gross Rent
  • MHP: between 3-5% of Effective Gross Rent

One final item to remember is the importance of professional management in securing your financing.  Even if you plan to self manage your onsite personnel, please build in approximately 5% of the EGR for asset management.  If the lender will consent to self-management, the money is in the budget to compensate you. If they require licensed approved management, you have the funds to cover the expense.

Diane Bowman
Rich Dad Education Elite Commercial Course Instructor

Commercial Lease Terms for Due Diligence

Commercial Lease Terms

Commercial Lease Terms

When you purchase commercial real estate you are purchasing the leases that are already in place.  In order to properly evaluate the investment, I have highlighted a few terms to assist you with the analysis.

Rent Types:

Gross vs Net:  Look at this the way you would look at your paycheck.  When a lease is a Gross lease you as the landlord still need to pay expenses such as repairs, and taxes and insurance from the rent you receive.

With a Net lease the tenant pays rent plus additional costs so you as the landlord are able to keep all the rent charged.   From a Due Diligence standpoint it is important for you to understand exactly what is to be paid by the tenant and what is to be paid by the landlord. The most common types of Net Leases are a single Net, which means the tenant will pay either Common area maintenance, real estate taxes, or building insurance.  Double Net or NN is when the tenant pays two of the above, and triple net is when the tenant is responsible for a share of all three.

Lease Length:

This is definitely a case where not everything you see is what you get.  You may have a lease that appears to be a five-year lease, but on closer examination you will see that it is really a two-year lease commitment and the tenant has the right to renew for 3 one-year periods, but not the obligation!

For instance the lease may say the tenant has a five-year lease through 2018.  When you read the lease it states that the tenant agrees to lease the space through 2015 and reserves the right to 3 one-year renewals through 2018.  What that means to you is that the tenants have locked you into a lease agreement long term and have given themselves the ability to cancel after two years.

Insurance:

As an Owner we typically want three types of insurance.  Replacement insurance to replace structures or equipment, liability insurance to protect from the operation or an accident, and income replacement insurance that will replace lost income from an insurable claim.  In order for you to get accurate quotes from your insurance agent, you will need to know what insurance your tenants are required to carry.  By example, if the lease states that your tenants are required to carry 3 million dollars of liability insurance you cannot purchase a policy that requires them to have 5 million.  You will also need to know what your lease states that the landlord and tenant obligations and rights are if the rental unit cannot be occupied.  This will make a difference in the type of income replacement insurance you may purchase.

Early Termination:

The “Break Clause” allows either party to terminate the lease early under certain conditions. By example, some well-known national tenants will sign long term leases but will build in a termination clause after 3 years.  This clause will allow the tenant to evaluate the market and determine if it is better to pay a fee, close up operation and move on or to continue the lease.

In most cases the termination fee should be significant in order to force the tenant to only terminate the lease under extreme circumstances.  I have, however, seen a few leases where the termination fee was as little as six months.

While the Break clause may sound scary it may also be used by landlords to eliminate tenants that are not adding value to a property.  This is especially true of a retail tenant.  Very often retail leases have performance clauses that state if the sales of a tenant drop below a pre-established amount, the landlord has the right but not the obligation to terminate the lease.

Subordination:

As a landlord you will want a subordination clause that states, “The tenants subordinate their rights to allow future financing and sale of the building.” Most lenders will not look at financing a property unless this clause exists because the Mortgage would then be in second position to the leases.

Holding Over:

Does the lease state what will happen if the lease term expires and the tenant remains in the unit?  The value of your commercial rental may be negatively impacted if you do not have leases in place.  Your goal is to have your tenants sign a lease renewal or give proper notice of intent to vacate so you can find another tenant.  If the tenant is indecisive and does not sign a renewal or give a notice of intent to vacate, they are deemed to be in a holdover period.  Many times a landlord will have a clause in the lease that states if the tenant goes into a holdover period the monthly rent will go to two times the last contract rent.  The goal of this clause is to force a tenant to make a decision.

Hopefully these few tips will help you to move forward in your analysis and I look forward to hearing about your progression.

Diane Bowman
Rich Dad Education Elite Commercial Course Instructor

Why We Train and Mentor

In writing this blog, I wanted to find inspiration from the Rich Dad Education Elite Commercial Courses I have just finished teaching. The participants were from varied backgrounds and varied skill levels and I felt if I found a common bond it would provide great insight for all our readers.

I went into the first weekend wondering which part of the training would receive the most attention from both classes. It was no surprise that in both classes the two subjects that spurred the most questions were the real estate cycle and the syndication deal structure. Since I have already written blogs on those subjects, I looked at the most serious moments of the classes and to my surprise in both classes it was when I was asked why I teach.

I remember asking the same question of my trainers when I was a student. “If you are successful in real estate why are you teaching?” To quote Nelson Mandela, “Education is the most powerful weapon which you can use to change the world.”

When I was a student, just like many of you, I wanted not only to improve my financial future but to also make a difference in the world. I quickly learned there is a fine line between sacrifice and suicide and on more than one occasion I needed to be reminded that this was to be a profitable business. An analogy I often use follows the airline instructions, “be sure to secure your own mask (future) before assisting others.” As our business grew, and about a year after I resigned from my job, I missed having people around me that wanted to talk about real estate. When an opportunity arose for me to mentor, I jumped at the chance. I am still constantly being reminded that I can only assist others if I take care of my own business and last year reduced my mentor schedule to just four mentorships.

Even with the cutback in my schedule I am still constantly asked why I travel so much and work so much. I have to ask, “why not.” Lots of wealthy and powerful people in the world work all the time. Warren Buffet, Oprah Winfrey, Donald Trump for example, you have to understand if you love what you do, it is not work. Financial freedom should not equal boredom.

All that being said let me share a few of the rewards from my teaching. I have had the opportunity to work in cities I did not even know existed and made friends around two countries.

I worked with a husband and wife from the Midwest. English was a second language for them and they struggled to understand the concepts of assignments. They stayed engaged in the mentorship for the entire 3 days but I came home feeling it would take a miracle to make them work the business. Two years later I received an email through the company website. They stated that their oldest son needed braces and the payments were more than they could afford. The couple worked the business exactly as taught and ended up assigning a deal for $2,500 the amount needed for the braces. They thanked me for their financial freedom, because freedom to them meant having the education and tools to provide emergency funds when needed.

A second student attended several Rich Dad Education Elite Courses but just did not have a desire for the business. He appreciated the knowledge but was not sure how he would put it to use. Less than a year later he approached me at a seminar and could not wait to share his story. It turned out no one in his family owned a home. When he chose to buy he was surrounded by negativity and fear. He was bursting with pride because he did purchase a home and he KNEW it was a great deal and no one was ripping him off. Now his family puts him on a pedestal and he is working to help an entire generation become home owners.

This weekend I was happy to have one of my many students who now work the business full time share their story with an entire class. The excitement it causes is contagious and it is wonderful to see the person to person motivation and positive reinforcement for life changing experiences.

I really only thought I would teach for a year or two to give back for those that taught me and to enrich my own business. Each year there is a time when I am ready to quit and then something great happens and I say one more year. As our business has grown my husband travels with me more and also stops in to share and answer questions.

I guess the best way to sum up why I teach is pull a line from a multitude of accessories I have been given over the years. They are gifts from the Leigh Standley line: “She packed up her potential and all she had learned grabbed a cute pair of shoes and headed out to change a few things. Her heart glowed with a degree of happy assurance.”

Diane Bowman
Rich Dad Education Elite Commercial Course Instructor

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