If you have ever read “A Tale of Two Cities,” you may recall the opening line of that book: “It was the best of times, it was the worst of times … ” And if you were seeking a commercial mortgage in 2006, it may well have seemed like the best of times. No guarantee. No problem. There were institutions seeking your business that were willing to offer non-recourse credit.
“It seemed like there were folks lining up to lend you money: the local bank, the regional bank, the multinational bank, the life insurance company, the finance company — each one had a hitch to make its deal enticing,” says John Guarini, second vice president, commercial lending, First State Bank.
Smart Business spoke with Guarini and Michelle L. Smith, first vice president, commercial lending, about how the real estate lending climate has changed over the past five years and the new realities of the commercial mortgage market.
How would you describe the real estate lending climate in 2006?
Guarini: Money was flowing from Wall Street to Main Street, and your local banker may have brought someone from the investment side of the bank to show you how to use an interest rate swap to obtain a payment lower than that on a standard bank-offered, fixed-rate deal. You signed that commitment letter, then all you had to do was pay your commitment fee — or maybe not — and an appraisal fee. Your loan was subject to the findings that would be set forth in that appraisal, but there was no way a 100-page report would hinder your loan because your building was fully occupied and rental rates were climbing.
After six weeks, your lender notified you that your appraisal had arrived, and the value indicated was even higher than he or she had thought, allowing you to borrow more money than you requested, and you said yes. Now, if you have to refinance, it may seem like the worst of times. You return to the institution that made the loan five years ago, and you may find it no longer wants to be in the commercial mortgage business.
How should a business go about refinancing in today’s climate?
Guarini: Get an early start, especially if the property you seek to refinance tends toward the more unique or single purpose. Occupied properties that fit this definition include restaurants, gas stations, car washes and hotels.
That means initiating a dialogue with your existing lender. A lender may want to exit a market segment or geographic area, so much so that a borrower may be able to obtain a discounted payoff without further recourse. Much depends on where your existing loan balance is in relation to the current property value. If your loan balance is 75 percent or less of the value of the property, you stand a better chance of refinancing.
Smith: It can take two to three months to navigate through the loan/appraisal processes, which starts all over if the first bank says no. We can’t emphasize enough — start early.
How is a property’s value determined?
Guarini: If you paid for an appraisal when your loan was written, contact the appraiser and update him or her on the status of the property. The appraiser may be able to give you a rough estimate of value based on current rental rates in the area and sales of comparable properties. Know your property, and the rental rates and prices area properties are commanding. What are vacancy rates? Are other property owners poaching your tenants? Are you willing to ask your tenants to sign early extensions of their leases to satisfy a possible requirement of your new lender?
Why is it important to understand the market?
Smith: Appraisal valuations are still driving loan transactions. However, many loans are limited by the sales and income approaches. Sales comparables reflect discounted and foreclosed sales, depressing price-per-square-foot values. Appraisers will mark the square footage of your property to average market rental rates to determine gross rent on an income approach. The higher of market or actual vacancy is then subtracted, less expenses, to determine net operating income. Appraisers are applying 9 to 10 percent-plus capitalization rates to net operating income to derive appraised value, and loan advances are more conservative, generally 75 percent maximum.
What else should you consider?
Smith: Cash flow is still king. Besides loan-to-value ratio, the lender will review the historical cash flow of the property based upon the last three years of tax returns. Be sure to explain why income was inconsistent or expenses spiked. Did you reduce rent to retain a good tenant? Are your taxes being reassessed? Minimum cash flow coverage is 1.2 times after factoring in a 10 percent or market vacancy factor, 5 percent management fee and possibly a structural reserve. Rates are low, a big advantage when calculating cash flow coverage. Use a maximum 20-year amortization when you pro forma the new loan payment; 30-year amortizations are a thing of the past.
Also, know thyself. What is your credit score? What is your global cash flow? Know the total of your business and real estate property rental income, minus expenses and debt obligations. Are you positive or upside down? Look at your portfolio cash flow holistically. Banks want to know if there is a dog that will take down their new loan.
What are the new realities of the commercial mortgage market?
Smith: More information may be required. Be prepared with tax returns, not only for the project you wish to refinance but also others in your portfolio. The lender will look at your other properties; the global cash flow must demonstrate the ability to service related debt at a minimum of 1.2 times also. Have full copies of leases, along with a rent roll that ties back to the latest tax return on the property.
Navigating shifting financial tides can be challenging. By investing time and expertise, you can aid the lender in finding equitable solutions. Savvy real estate investors find a way to make it rain in good times, and bad.
John Guarini is second vice president, commercial lending, at First State Bank. Reach him at (586) 445-1022 or [email protected] Michelle L. Smith is first vice president, commercial lending, at First State Bank. Reach her at (586) 445-4762 or [email protected]