Reality Vs. Fantasy in Commercial Financing

During the past decade the U.S. economy has been riding a steep roller-coaster. The Dot-Com bust had been extinguished by another bubble, one of a much larger proportion that had a severe impact on the entire world. In 2007 the Real Estate bubble burst and its effects had triggered a near collapse of the financial sector. The Commercial real estate sector has yet to be exposed when loans become due and banks will not be willing to renew them, an event that may very well cause a multitude of commercial real estate owners to default.

Money is tight and lenders are cautious. Yesterday’s reality is today’s fantasy when it comes to commercial financing. For those investors that are in need of financing and are looking for a successful closing there are two primary guidelines worth following. A viable project combined with viability of the investor’s qualification.

Viable Project

The first question to ask yourself is how much risk would the lender incur financing your project? Lenders assess their risk by studying the local economy and the need for such a project. They also consider the worse case scenario, in other words what they would do if they had to foreclose on your property. They always assess the possibility of default no matter how great of a project you have. Loans on raw land is fantasy in today’s financing arena due to its inability to generate income unless it’s improved. If the lender had to foreclose on unimproved land it would be very difficult to sell it. New construction is another hard – if not impossible – to finance project. In an area where there are already many distressed vacant properties a lender won’t be inclined to take the risk no matter how great the figures on a proforma might look. They know projections are…simply projections, plans that are not necessarily guaranteed to work.

How much risk the lender is willing to take lending on your project is determined by the LTV (Loan to Value) or LTC (Loan to Cost). A submission for a 100%, 95%, or any high ratio is simply a waste of time for all parties involved. With a very few exceptions the high ratios do not exist. And chances are your project has a high likelihood it won’t be an exception. What’s realistic then? 70% (best case scenario 75%) or below on conforming deals and 50% to 60% on non conforming deals, and it won’t be on values from past years’ appraisals. Often the underwriter will reduce the current appraised value to an even lower level just in case they need to foreclose within 3 to 4 months.

Another factor of utmost importance is the DSCR, a calculation that shows the property’s ability to cover the proposed debt. The lender wants to see that for each dollar of debt there is a minimum $1.25 in net operating income. Many lenders would rather see a minimum of $1.35 or more. When calculating the proposed debt another reality needs to be brought in the equation. At what interest rate one might consider the loan. All too often investors calculate the rate at the lowest figures seen on advertisements. So, if one is to calculate his potential DSCR at a 5% rate and that figure is barely at 1.25 be assured there is a high likelihood there will be no closing.

Vacancy levels are scrutinized and play a very important role during the financing process. High vacancy for longer period of time leads to lower operating income, lower values, lower DSCR, and a slim to none chance of approval. Many investors rely on their realtors or property managers to secure tenants however when the vacancy level has been high for a long period of time it might be a good idea for the property owner to get actively involved. Buying distressed vacant property in need of rehab work is even more challenging to finance since the conforming approach is not realistic. At that point hard money or bridge loans are most likely the best fit with lower LTC ratios (up to 70%) and a solid exit strategy.

If your project has passed preliminary tests and makes it to the level of Conditional LOI (Letter of Intent), know that appraised values from the recent or distant past have little significance to lenders today. Values have dropped and they have not yet reached their lowest levels in the commercial sector. Lenders will ask for a new MAI appraisal and they will order the report from their approved sources, report that investors must pay for upfront. In certain cases the lender will also ask for a Feasibility report from a reputable company.

Viable Investor

A feasible project represents a lost opportunity for an unqualified investor. Qualification is considered based on the credit and financial strength of the client borrower. The liquid funds invested and the reserves allocated for the specific deal play an important role. Lenders must be convinced that sufficient capital is being contributed by the investor when evaluating their risk.

A well-prepared loan package consists of a professionally executed Executive Summary, up-to-date Financial statements, most recent three years of Tax returns, year-to-date Profit & Loss, Rent roll and/or three years Proforma, a detailed explanation for the funds requested, a Bio of the investor evidencing solid experience and success in the field, a Resume of the property manager, pictures of the property, and for the non-permanent financing request a clear and concise Exit Strategy. If the investor is a separate entity (Corporation, LLC, LLP) Articles of Incorporation or Certificate of Organization along with the Operating Agreement should also be included. If the property is leased out the lender will ask for all lease agreements. When distressed property is in need of rehabilitation a complete Breakdown of costs should also be part of the package.

Clients who are not able to provide such a professional package or brokers not asking for one are merely wasting their time. Lenders will simply not entertain a loan request on a verbal request or a poorly presented package. There is a high demand for funds with a limited supply in today’s economic climate so the one who has his act together wins.

Another unrealistic request that investors have not yet fully grasped is the idea of getting a non-recourse loan. Gone are the days when the borrower did not have to provide a personal guarantee. Today in 99% of the cases lenders will not be satisfied with the collateral only. Therefore expect to provide the personal guarantee.

Shopping numerous funding sources for a half point lower rate is another way to waste time and energy. Smart loan professionals can quickly spot an unrealistic and/or uncommitted borrower. As an investor you will gain by finding and establishing a strong business relationship with the loan professional that can guide you to a successful closing or like in many cases tell you why your project is not viable. You should be able to assess how experienced is the individual you’re considering based on the questions he asks, the documentation he requests from you, and his thoroughness on why your loan project is real or not for financing. If he tells you everything you want to hear, offers you the lowest rates, the highest LTV’s, or that he can close within 30 days, it’s time that you look in another direction. A good one is hard to find but once found the relationship should be valued just like you value your relationship with your accountant.

If all of the above make sense when presented to the lender – and meets the criteria – the deal becomes real and the lender will most likely want to have a conference call with you. If the call is successful a Term Sheet along with a conditional LOI follows. At this stage the lender is interested in further pursuing your loan request and as a borrower you must be prepared with a Due Diligence fee. This fee covers for the cost of appraisal, title search, and in many cases the cost of traveling to visit the property and meet the borrower. If the loan does not close – typically because of any new discoveries that are negative – the fee is non-refundable.

A word of caution…if it’s too good to be true it ends up being too good to be true. If you and your project don’t meet today’s realistic lending criteria – many of which have been mentioned above – and for whatever reason you get a conditional approval, common sense should tell you that you’re not dealing with a viable financing source. Expect tough lending guidelines to be around for a while however the more investors get used to the idea that the good old days of easy financing are gone, the better prepared they become, and the better chances they have to be first in line for commercial real estate financing.

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12 thoughts on “Reality Vs. Fantasy in Commercial Financing

  1. I’m just looking for a larger marina to fall out of the coming crisis. Lenders ending up holding larger marinas as OREO assets, not knowing with to do with them. I want to meet the right OREO managers, and negotiate management contracts (unless you want to keep the previous owners in control), percentage leases, or leases with options to purchase.

    Out of every crisis come needs and opportunities. Only the wise will keep their wits and make things work out.

  2. Well said, Carmen! Here’s THE most important factor I’ve run into in the last 36 months: LIQUIDITY!

    I was able to secure a non-recourse loan within the last 12 months for growth capital tied to FFE and receivables from a local bank that my client had done business with for nearly a decade, so there are some circumstances where non-recourse loans are available, but very, very few.

    I have reviewed hundreds of Executive Summaries and Pro Formas – and the vast majority never make it past the review stage with me, as a commercial finance broker. I promise one thing: If it cannot be funded, I will give you an answer within 48 hours of why not, specifically.

    Oftentimes, this simple request for initial review docs gets me a full business plan and financials. I don’t have time to review documents at this level in an initial review, for which I do not charge a fee. It’s a free analysis.

    If it goes beyond that, a second-level request for docs includes the full business plan along with a current PFS on each owner and each entity tied to each owner, CVs which clearly demonstrate their experience in the business for which they are seeking funding, tax returns (3 years), etc. If this is a purchase of an existing business such as a hotel or retail shop, I am asking for those financials and tax returns from the seller(s). If it’s a cash heavy business such as a nightclub, I am requesting all liquor receipts for two years from the seller. C-stores with gas pumps and other environmental impact related purchases, require EI or EII level studies, completed, for the loan package.

    One of the most vexing things I come across is the lack of due diligence prior to a reaching out to me, or even worse, having given my best advice, seeing the same holes 18-24 months down the road when I am once again approached. I am referring to market data, the competitive landscape (so many downplay that with “we have a better widget” with no consideration that the first mover could integrate “better widget” elements into their business without much cost or effort), lack of credit worthiness, lack of liquidity, no substantive cash investment – “time spent on the project” or “sweat equity” do not count.

    I wish all entrepreneurs the very best. Be prepared and you might realize your dream!

  3. The lending climate has indeed changed. You have the reality of human emotion where rising markets cause us to forget that they also fall, and fallen markets have us forget that they do also rise. This native tendency is vastly exacerbated by the central direction of fiat currency, which is bound to mischief on both counts, and only exaggerates both boom in bust. In its absence both would be relatively minor, local, and benign to most of us. I think it was in Human Action that Mises described lending as “mostly gratuitous.” Still, the documentation you describe, which lenders may or may not thoroughly read but certainly are taken as evidence of professionalism, due diligence, and sound research, is a necessity to moving forward.

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