Commercial Loans: What Works, What Doesn't: Got excellent credit, property, occupancy and income history? Great!--Now prove it!Serafim Ivaskdocumentation, presentation, commercial loan package
In residential cases, the success or failure of an application
often depends on the accuracy and consistency of the submitted
information. It is much the same, and perhaps even more so, with
commercial loans, since one can not hide behind some variant of a
"No Doc" provision. Either the documentation (read: proof!) is
there or it is not. Income qualification processes itself because
commercial loans are very straightforward. All we need to do is
provide sufficient, accurate and consistent evidence to support the
income and expenses. The borrower and the property may then be
eligible for competitive, long-term, fixed-rate programs such as
those offered through Wall Street conduits or life or major credit
companies. If the information is not credible or is missing, there
may still be other short-term financing alternatives available to
the borrower, until supporting acceptable documentation is
presented to qualify the deal for a loan on more favorable terms.
In this month's article, I will concentrate on the form and
substance of the documentation that you will need for most of your
cases seeking permanent financing.
For the balance of this article, pretend that you are the
lender. It is your money that will be at risk once
you lend it. Your primary goal is to make money on your money, not
to lose it or squander more money getting it back from the
borrower.
Stay Focused--and Keep It Easy!
It is often suggested that you should try to go for the larger
loans, preferably, well above $500,000. Among the several reasons
for choosing larger loans is the issue of "ease of originating" the
loan. One key item that determines whether a deal is difficult or
easy to close is the ease with which you can collect the required
information. If you have to beg, argue and wait forever for the
documents requested, you are losing time and money on the case!
Clients requiring larger loans tend to have better record-keeping
habits. The larger the loan request, the higher the probability
that the client or seller employs an accounting firm or property
management firm to keep track of the property's cash flow. The
management company's income usually depends on the property's
performance. Therefore, there is less likelihood that tenants pay
by cash, and even less that significant portions of the income are
under-reported. Remember, you may have an excellent property and a
client with good credit, but if you can not prove the property's
income, you may not have a case.
Ownership Structure
The first thing to establish is the "owner entity." Generally,
commercial properties are owned by single asset entities,
corporations or partnerships who do not own any other real estate.
They are formed for the sole purpose of owning one specific
property. This way, problems or issues affecting other properties,
or other business dealings of the shareholders, do not flow over to
affect matters for the subject property. Each single asset entity
files its own tax returns and financial statements, has its own
bank accounts, and generally does not mingle its financial
resources or reporting with that of other "sister" entities or the
shareholders. The owner entity structure is easily established by
obtaining copies of the certificates of incorporation, filing
receipts, copies of licenses and permits.
Income
For a multi-tenanted property, the income is typically
established by reviewing several or all of the following documents:
leases, property income and expense statements (preferably prepared
by a CPA), tax returns, bank statements, copies of canceled checks
and--if required by local laws or regulations--other filings with
the appropriate municipal or state authorities.
Copies of leases are required for all legally-rented commercial
and residential space. They will be reviewed for the lease start
and end dates (to establish how much time is left before the lease
rolls), dates of initial occupancy (to help establish stability),
any options such as early termination by either the landlord or
tenant, the rental amount and any rent escalation clauses being
compared to market values obtained from the appraisal report, any
additional income the landlord may be entitled to, such as parking,
laundry or reimbursement for any expenses, and the tenant entitled
to any credits from the landlord.
Income and expense statements, or operating financials
(reflecting only the figures associated with the specific property
in question) prepared by a CPA, should cover at least the last full
year of operation. Most programs require two or three years, plus a
YTD statement, as well as a current financial statement showing the
current assets and liabilities of the owner entity. Furthermore,
underwriting may require a separate statement showing the last 12
consecutive months of operating history. For larger properties with
many tenants and expenses, this is often very important, and can
often benefit of the client since this clearly shows any trends.
Such CPA-prepared operating statements allow for notes, comments
and explanations which are not possible on tax returns. It is
easier to read and follow these CPA-prepared statements than tax
returns. Obviously, all of these must be consistent with the tax
returns--original or amended--with which they will be checked.
Usually, at least the last three consecutive bank statements
covering the property management account(s) will be required. The
intention is to demonstrate ongoing deposits into the account of
sums reflecting the stated rental and other income, as well as show
the actual outgoing expense payments. Often, a full 12 months of
such bank statements will be required. A careful underwriter may
also request to see a copy of the ledger as well, which should
match the information on the bank statements and leases. The ledger
comes in handy when more than one bank account is used, or the
presence of other complications makes it difficult to track the
property cash flow solely from the bank statements. If the owner
collects cash from the tenants, the rental income can still be
corroborated by the ledger entries, as well as periodic and regular
deposits into the bank account(s) of the appropriate sums. These
are evidenced by entries on the bank statements and copies of
deposit slips. Regular deposits are very important since irregular
or sporadic deposits suggest collection problems.
Cases in which one tenant occupies a significant portion of the
total available space, it may be necessary to obtain financial
information on the tenant as well. This is done to show that this
critical tenant has the ability to pay the market rent. Typically,
this is easily achieved by reviewing the tenant's cash flow from
either tax returns or CPA-prepared operating financials. If the
tenant is a known public company or a major, rated corporation, the
process is simplified since this information can be easily obtained
through the Internet. Also if the tenant happens to be a company
such as IBM or Microsoft, you are certainly free to skip this step
altogether.
Expenses
In theory, expenses should be easier to establish and require
less documentation. Typical expenses for income producing property
include property taxes, insurance, utilities, ongoing repairs and
maintenance, management fees, sewer and garbage/trash removal,
professional services such as tax preparation or legal fees,
salaries, and contract services such as snow removal or
landscaping. Ultimately, the appraisal company will comment on the
rationality of the claimed expenses.
Property taxes and insurance costs are typically documented by
showing copies of the most recent tax bill and insurance invoice.
These bills actually show both the amount of the ongoing obligation
as well as confirm that these are current at the start of the
process, at least up to the date of the invoices. The final
confirmation of these figures will come from the title report and a
new invoice from the insurance company just prior to closing.
Utility costs will be shown in the income and expense statements,
property owner's tax returns (or schedule E for individual owners).
If necessary, these can always be confirmed with the utility
companies.
Ongoing repairs and maintenance costs are just that--ongoing. If
capital improvements are included, these will skew the expenses,
reducing the Net Operating Income (NOI) and, thus, reducing the
maximum-allowed loan amount. A quick indicator that something is
wrong may be a significant change in reported figures over the last
few years. Remember that underwriting looks for historical figures
and trends in evaluating the property's ability to carry a loan.
Having at least three years of expense figures before you,
inconsistencies are easily corrected before submitting the
loan.
For underwriting purposes, management fees will be assumed at
approximately five percent of the rental income or, if they are
higher, the underwriter will use reported figures. This is still an
expense item for "self-managed" properties since, in the event a
lender must take over a property, the services of a management
company would have to be retained.
Owner's or Shareholder's Information
The two items of information needed about owners/shareholders of
a "single asset" property owner are the condition of the credit
report and their experience as property owners or managers.
Generally, credit scores below 650 for any shareholder or partner
owning more that 20 percent of the single asset entity will begin
to interfere with your ability to deliver a good loan to the
client. If credit is an issue with one of several parties,
restructuring the shareholder composition may sometimes offer a
solution. In cases where several parties own approximately equal
shares--all less than 20 percent--it will be important that the
parties with good credit are the ones that have management control
of the operation.
Generally, tax returns are collected from the majority or
management shareholders, not so much to evaluate their income, but
more for the record. It is still the property financials that will
determine the loan amount. However, if the shareholders are also
tenants on their own property, it may be important to review their
ability to pay "themselves" the appropriate market rent, especially
if the occupied space represents a significant portion of the total
space.
However, it is important to obtain recent financial statements
from all key shareholders. The age of these financial statements
should not exceed 60 days and should accurately represent of their
financial strength. While many loans do not ask for personal
guarantees, they still have standard recourse provisions for cases
of fraud, embezzlement or judicial action. A personal guarantee by
a client with little net worth has little value.
The owner's experience is evidenced by a resume, as well as from
the contents of the financial statement, and even the credit
report. Typically, borrowers ought to have the experience required
to manage the property or be prepared to hire a management company
to do it for them. Here is the management fee. If the property is
relatively small and the borrower has excellent credit, reserves in
the bank, some business experience and is putting down a
substantial down payment, there may not be an issue. On the other
hand, a borrower who does not own a primary residence, has never
owned or managed any commercial or rental property, has little
reserves and is now purchasing a 50-unit apartment building--this
borrower's ability to manage the property will undoubtedly be
questioned.
Property Information
The required documentation is essentially the same as that
needed in residential cases. In a purchase transaction, the
contract of sale identifying the parties is needed to specify the
purchase price and any other relevant terms and conditions of the
sale, such as seller financing, occupancy stipulations for the time
of deed transfer or needed repairs. In a refinance, we would look
for the deed. Always obtain a copy of the C of O, survey, location
map and color photos of the property. Sometimes, internal photos
may also be helpful, especially if there is an attempt to show
significant interior improvements to the property. If any recent
capital improvements were done to the property, this is the time to
mention those improvements and their costs. Copies of old appraisal
reports, as well as old engineering or environmental reports, would
also be helpful. As a minimum, copies of old "third party" reports
may save you time.
Conclusion
If it was your money that was being lent, you would certainly
expect the underwriter to review all of the above material to
confirm that the borrower indeed has the ability to make payments
and would continue to repay loans in the future. You may even feel
compelled to request additional material at times, just be certain
that your lending decision is based on sound judgement. Therefore,
as you collect the documentation, always question each document,
not only for legitimacy, but also for content. Does the document
fit the rest of the "presentation" and does it support the loan
request? If your answer is "yes," you have accomplished your goal.
Remember that the borrower will be happy to give you all the
material you need, provided that you ask for it in a professional
manner and the client understands exactly why the requested
documents are important to the underwriter.
Serafim Ivask has been actively involved in the mortgage
industry for more than 14 years and is product development manager
for CrossLand Mortgage Corporation, now part of the Wells Fargo
Family of companies. He may be reached at (631) 843-9000 or (631)
874-3256.
