Harbor City Real Estate Advisors, LLC - Investor Learning Center

510 Live Oak Drive
Mount Pleasant, SC 29464

843.805.8011 tel
843.805.8012 fax

HARBOR CITY INVESTOR LEARNING CENTER

MESSAGE FROM BROKER/TOC
A. MEASURING AND COMPARING INVESTMENTS
B. REAL ESTATE FINANCE
C. PURCHASE AND SALE ISSUES
D. LEASE LINGO AND LEASE NEGOTIATION ISSUES
E. TAX ISSUES

B. REAL ESTATE FINANCE

1. What Is “Leverage”? Why Is It Considered a Benefit of Real Estate Investing? What Are the Downsides to Leveraging a Real Estate Investment?
The power of “leverage” is one of the primary reasons why real estate investments can both yield dramatic profits for some investors and result in disaster for others. Leverage simply refers to the ability of an investor to purchase an asset using borrowed funds. If the real estate investment ends up yielding a rate of return that exceeds the loan interest rate, then the investor is said to benefit from “positive leverage” because the investor not only gets a positive return on his downpayment, but he also makes money on the borrowed funds used for the investment. That having been said, many investors have learned the hard way about “negative leverage”, where the cost of borrowed funds exceeds the yield on the real estate investment.

2. What Issues Should I Focus On When I Negotiate a Commercial Real Estate Loan?
Lenders are notoriously inflexible when in comes to negotiating loan terms at or near the closing. Thus, a borrower should negotiate all important loan terms early in the process and these terms should typically be memorialized in a written loan commitment letter.

Below are some issues to consider when negotiating a loan commitment:

Interest Rate. This is the most obvious issue. Some lenders will offer an alternative between a fixed rate and a variable rate. Often, they will agree to a variable rate that has a floor (advantageous to the lender), a ceiling (advantageous to the borrower), or both a floor and a ceiling.
Loan Amount. A lender will typically want to see a substantial cash investment by the borrower. For income producing properties, lenders typically want at least a 20% downpayment by the investor (see discussion below of “loan to value ratio”), although the required downpayment will vary depending upon the lender, the borrower, and the type of property involved.
Term. The most common loan term for a commercial investment is five (5) years. The most common exceptions are: (a) construction loans, which typically have a shorter term in the range of six (6) months to two (2) years, depending upon the scope of the project; and (b) “permanent loans” for stable income-producing properties, which typically exhibit longer loan terms (up to 10, 15 or 20 years). The modern real estate market now features numerous “hybrid” loans with various features and options. For example, so-called “mini-perm” loans may allow a borrower to extend the term of a construction loan beyond the construction period.
Amortization. Even though a loan may only feature a five (5) year term, the regular payments of principal and interest are typically calculated over a longer period, resulting in a “balloon” payment being due at the end of the loan term. Fifteen (15) years is a common amortization period for commercial loans, although investors with strong credit or strong banking relationships are sometimes able to obtain a twenty (20) year amortization, resulting in better cash flow to the investor.
Guaranty. Most loans require a personal guaranty. In certain circumstances, a borrower is able to negotiate a loan that does not include a personal guaranty (most commonly associated with “permanent loans” for stable, income-producing properties). In other circumstances, a lender may agree to cap the guarantor’s liability at a certain dollar amount.
Loan Origination Fees. A one percent (1%) loan origination fee is common. However, the amount of the origination fee is very often negotiable. In some cases, a strong borrower can reduce the origination fee to a “half point” (0.5%).
Other Loan Closing Costs. Some lenders will require that the borrower pay for various due diligence and legal costs associated with the lender’s review of the property and preparation of loan documents. The loan commitment stage is the best time to try and have some of these review costs waived or capped (e.g. a borrower might persuade a lender that a new Phase I environmental report is not necessary for a particular property).
Collateral. In almost all real estate loans, the subject real estate is mortgaged to the lender. However, a lender may also seek additional security in the form of personal guaranties, letters of credit, pledged stock, pledged LLC interests, or pledged bank accounts. Again, this negotiation should be handled at the loan commitment stage.

3. What Is Meant by the Phrases “Loan To Value Ratio” and “Debt Coverage Ratio”? How Does a Lender Use These Ratios to Analyze a Potential Loan?
The two formulas that are most frequently utilized by lenders to evaluate a potential loan are the “loan to value ratio” and the “debt coverage ratio”. Often, a lender will apply both ratios to a particular investment and only lend the maximum amount that meets their criteria for both formulas.

Loan-to-Value Ratio. The “loan to value ratio” is a ratio generated by comparing the amount borrowed to the value of the property (value being measured either by the purchase price, the appraised value, or sometimes the lower of the two):

Loan-to-Value Ratio =	Loan Amount

	Property Value

The most common “loan to value ratio” requirement for a commercial investment is eighty percent (80%). For some specialized properties (such as hotels), a lender may demand a more significant downpayment. However, lenders will sometimes lend up to 90% or even 100% of an investment’s purchase price where the loan is deemed highly desirable to the lending institution. For instance, a physician borrowing money to purchase an owner occupied medical office building can often obtain 100% financing of the investment.

Debt Coverage Ratio. The “debt coverage ratio” is a ratio generated by comparing the annual net operating income of the property (gross income minus all property expenses paid by the property owner) with the annual debt service (annual payments of principal and interest) associated with the loan.

Debt Coverage Ratio =	Annual Net Operating Income

	Annual Debt Service

Lenders use this type of analysis to make sure there is adequate income to meet the borrower’s obligation to make loan payments. For instance, a required “debt coverage ratio” of 1.20 means that the bank will not make the loan unless it becomes satisfied that annual net operating income exceeds annual debt service by at least a twenty percent (20%) cushion. This type of ratio is typically applied to loans for income producing property. It would not be applicable to a land loan, since a parcel land with no improvements does not typically generate significant income.

4. Aside From Financial Ratios, What Are the Other Important Considerations for Lenders in Evaluating a Commercial Real Estate Loan?
A lender will look at a wide range of other factors in evaluating a potential loan, including: (a) the credit and net worth of the borrower and any guarantors; (b) the location and marketability of the collateral, including neighboring uses; (c) the quality of the tenants; (d) length of lease terms and the legal rights and remedies set forth in the written leases; (e) the type of use and potential vacancy rates associated with that use; (f) the size of the requested loan; and (g) the age and quality of the improvements (e.g. Class A office space may be preferred over Class B office space).

5. What Are the Primary Methods Used by Professional Appraisers in Appraising the Value of Commercial Real Estate?
There are three principal methods used for appraising real estate:

Sales Comparison Approach. Using this approach, the appraiser reviews the price paid recently for similar properties, but makes adjustments for positive and negative variances between properties. This approach does not work well when there is only a small number of comparable sales to review.
Cost Approach. Using this approach, the appraiser determines a land value and then separately values the improvements by evaluating the current cost of reproducing the improvements. Further adjustments are then made to reflect depreciation in value associated with age, “wear and tear”, and other factors that may have contributed to making the improvements more obsolete. This method is useful when the sales comparison approach cannot be effectively applied because the property is unique and there are very few comparable sales.
Income Approach. Using this approach, the appraiser generates a value by analyzing the income associated with the property. An appraiser may use a “cap rate” but may also employ more sophisticated financial analysis models. This method is most appropriate for income producing property.

It is not unusual for an appraiser to apply each of the methods above, sometimes resulting in three (3) different values for a property. The appraiser may then average those values to arrive at a final value. Alternatively, if the appraiser determines that one method is more suitable for a particular property, the appraiser may give greater weight to that method in arriving at a final value.

6. What Is a “Non-Recourse” Loan? Under What Circumstances Will a Lender Consider Making a Non-Recourse Loan?
A “nonrecourse loan” typically refers to a loan where neither the borrower nor the guarantor has personal liability for repayment of the loan. Typically, these loans are only made where the loan is secured by a stable, income-producing property, such that the lender has a high level of confidence in the ability of the property to consistently generate positive cash flow. Even where a lender agrees to make a “non-recourse” loan, the lender almost always identifies “carve-outs”, or special situations (e.g. misappropriation of insurance proceeds) in which the borrower and the guarantor will face personal liability for repaying the loan.