Commercial mortgage borrowers come at all levels of experience, from experts to novices. However, successful borrowers have one thing in common.
Successful commercial borrowers understand that owning commercial real estate is a “business” and any loan against commercial property is a “business loan.”
To put this into perspective, let’s look at a “residential home loan” versus a “commercial home loan.”
Given a well-qualified residential mortgage borrower, the lender looks for “borrower income” to back the loan.
Given a well-qualified commercial mortgage borrower, the lender looks for “property income” to back the loan.
Taking this concept a step further, commercial real estate is typically viewed as a “business within a business” 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 being offered for a loan, in any Loan-to-Value (LTV), must generate enough cash flow to cover:
- The normal operating expenses of the property.
- The lender’s required reserves
- Monthly principal and interest payments
- Plus, additional cash flow earnings to cover the investment risk of owners and lenders
In short, the Lender, as a business investor/partner in the property, should feel comfortable enough to expect the property to continue operating profitably under the Lender’s absent management, if necessary.
Now, let’s put the above into practice so that you, as a prospective commercial borrower, can pre-screen (underwrite) a sample income property that we’ll assume you want to purchase.
Assume a 6-unit apartment building with each apartment rented for $910 per month. The seller is asking for $500,000 and his tax returns show that his real estate taxes on the property are $10,000 per year, insurance is $3,500 per year, and common utilities are $1,450 per year, including yard care, since that each unit pays its own utilities. Your lender requires a 20% down payment.
You can do the following quick analysis by creating a simple spreadsheet:
Gross rents are $65,520 — or 6 apartments x $910 x 12 months.
We will then 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
The expenses reported in the Owner’s Return for Real Estate Taxes, Insurance and Common Services will be deducted from the Net Rent, which add up to $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 ensure that 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 generates a gain for the buyer/investor ($44,018 – $36,683 equivalent to $7,336), but also adds an additional cash flow safety margin to satisfy the lender’s risk aversion.
Now, dividing the earnings-adjusted NOI by 12 will give us the monthly principal and interest (P&I) payment that this “commercial property” can support to make it acceptable to an interested lender. This split results in a proposed monthly P&I payment of $3,057
Using an online mortgage calculator, we can determine that $3,057 at an interest rate of, say, 8%, amortized over 30 years, equals a home equity amount of approximately $399,797.
Because the principal amount derived from the mortgage is essentially equal to the $400,000 needed to purchase this property at 80% LTV, if the buyer’s credit, experience, and liquidity are acceptable to the lender, this property will most likely qualify. with the lender’s requirements to receive financing at the requested price.
As a result of this simple analysis, the buyer not only knows that he can obtain the necessary commercial mortgage to purchase his new investment property, but he also knows that the property will provide him with an annual return on cash flow (ROI) of $7,336 per year. or about 7.3% return on your invested cash.
Now let’s assume that the property above is a 6-unit “Office Complex” with the same sales 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 who currently rents 2,000 square feet of space for $2,000 per month.
This borrower wants to build capital not only in his business, but also in commercial real estate rather than enrich his Owner. Therefore, you are investigating the purchase of the commercial property from the former Office Complex, as Owner-Occupant, planning to have the property held in a separate LLC holding company that will lease two (2) of the units to your company (33% ) and will keep the remaining tenants on long-term leases.
Looking at the analysis above, simple math tells us that this borrower can reduce his business’s monthly rent to $1,820, saving his operating business $2,160 per year in rent, while his LLC holding company makes a profit. of $7,336 per year. Additionally, your business rent for two units, plus the rent from the remaining tenants, will strengthen you by continually increasing the value of the commercial property each month as the combined rents pay off the mortgage.
In truth, the above Investor and Owner Occupant scenarios are even more attractive than the ones presented because of the tax advantages of commercial property, but that’s a topic for another time.
In summary, if you are a prospective purchaser of commercial property, whether as an investor or owner occupant, you now understand that any commercial property you wish to purchase must generate sufficient cash flow to cover all expenses, reserves, the proposed P . & I, —- more show a benefit!
Understanding this simple concept and using it will save you time and frustration, give you advantageous leverage with sellers and lenders, and ultimately land you in the promised land of owning a portfolio of “profitable” commercial properties.
By simply creating a small spreadsheet that resembles the analysis above, you too can pre-analyze (underwrite) most commercial property transactions like an expert!