Handbook for Commercial Mortgage Borrowers – Lesson #1

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 “commercial loan.”

To put this in perspective, let’s look at a “residential mortgage loan” versus a “commercial mortgage 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, under any Loan-to-Value (LTV), must generate sufficient 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, must be comfortable enough to expect the property to continue to operate profitably under Lender’s absentee management, if necessary.

Now, let’s put the above into practice so that you, as a potential 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 renting 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 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.

Next, we will reduce the gross rents by 10% to cover the reserves required by the lender 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 that add up to $14,950 will be deducted from the Net Rent

After the previous 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 “NOI adjusted for earnings” 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 margin of safety 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 be 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 mortgage principal 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 asking price.

As a result of this simple analysis, the buyer not only knows that they can obtain the necessary commercial mortgage to purchase their new investment property, but they also know that the property will provide them with an annual cash flow (ROI) return of $7,336 per year. or about 7.3% return on your invested cash.

Now suppose the above property 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.

Also assume that our borrower is a successful service business owner who currently rents 2,000 feet of space for $2,000 per month.

This borrower wishes 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 previous Office Complex, as Owner-Occupied, planning for the property to be held in a separate LLC holding company that will lease two (2) of the units to your company (33% ) and will retain the remaining tenants on long-term leases.

Looking at the above analysis, simple math tells us that this borrower can reduce his company’s monthly rent to $1,820, saving his operating company $2,160 per year in rent, while his LLC holding company makes a profit. of $7,336 per year. In addition, your company’s rent for two units, plus 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 those presented because of the tax advantages of commercial property, but that is a topic for another time.

In summary, if you are a prospective buyer of commercial property, either as an investor or owner-occupier, 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 profit!

Understanding this simple concept and using it will save you time and frustration, give you advantageous leverage with sellers and lenders, and ultimately lead you to 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 preanalyze (underwrite) most commercial property transactions like an expert!