Deliver the Details
Maintaining accurate records can help property owners obtain the best financing.
In many markets commercial real estate professionals rely on small properties as the backbone of their business. Unfortunately these properties sometimes fail to qualify for the maximum amount of financing required, which may prevent owners from selling at optimal prices. Sometimes these buildings don’t sell at all because the underwriters who fund the loans receive contradictory, incomplete, or misleading information.
Many failed transactions result from property owners who lack knowledge about the types of records underwriters need to provide requested financing amounts. For example, property owners must maintain and provide accurate, detailed expense and income records that underwriters can verify, not summaries. While maintaining these records is the building owners and managers’ responsibility, commercial real estate professionals can help guide the process of presenting financial information to lenders.
Guiding the Way
Proactive brokers can facilitate deal closings by making sure that building owners and managers assemble and present the proper materials to lenders. Once accurate records are assembled, property owners, building managers, and real estate brokers should review them to ensure that all actions necessary to sell the property have been implemented. For example, if deferred maintenance accounts for more than 5 percent of income, it may alter the deal and should be addressed before selling the property.
Some owners fail to explain and separate non-property-related expenses unless their brokers prompt them to do so. Owners should remove certain corporate expenses from a property’s operating expenses. For instance, suppose a landlord pays family medical insurance premiums from rental income. Although that arrangement may provide a tax advantage, it also could reduce the property’s value since it lowers net operating income. If property owners fail to keep accurate records, such extraneous expenses can have a negative impact on income and drive down an asset’s value.
A more common problem arises when the line between capital expenses and operating expenses is erased. Operating costs should be broken out and itemized as operating expenses. But placing capital expenses into the operating expense category reduces the loan value of the property. Increased operating expenses result in decreased loan values, while capital expenses — including investments in the quality of a property — may enhance a property’s value and create higher loan values.
All Things Considered
Owners also should break down income into the appropriate categories. For example, at one property, rent rolls cited that apartment tenants were paying $850 per month for two-bedroom, one-bathroom units, which was substantially above market value. Since lenders underwrite to market rent as a maximum, properties don’t receive NOI credit for any above-market rents. As a result, this property fell short on the requested loan proceeds.
Upon further investigation, it was discovered that the property had storage units that other competitive properties did not have, and the units were being rented to the tenants separately. The building owner had “simplified” his records by combining the apartment rents with the storage-unit rents. This information made a significant difference and the full requested loan amount was provided.
It’s important to note that the building owner never offered the storage-unit rental information; some of the ledger entries tipped off the underwriter. This small detail could have made a difference of more than $1 million in loan proceeds — easily a deal breaker in a transaction of this size.
Concessionary leases pose another kind of problem as rent concessions discovered late in the loan process can be financing time bombs. If a tenant has received several months of rent-free occupancy, the tenant’s lease should be prorated to show the real monthly rental income.
If between 20 percent and 40 percent of retail, office, or other commercial tenant leases terminate within six to 12 months, landlords should work to extend those leases. Otherwise, loan proceeds may be drastically reduced, or it even may be impossible to find a lender willing to fund the deal. An alternative to extending leases is a reserve held in escrow to cover the loss of rental income and anticipated rollover costs. Some landlords offer expiring tenants lease extensions at below-market rents. This does not work to a landlord’s advantage as it decreases the loan amount the building can support.
In addition, the following physical challenges should be considered when requesting financing. Often these factors are necessary to bring the building in line with comparative properties.
- If suburban office buildings don’t have sufficient parking spaces for all tenants, landlords should make arrangements with adjacent properties to rent additional parking.
- Restrooms should be enlarged or additional facilities added if they are not sufficient to accommodate the number of tenants.
- Buildings should be wired for high-speed Internet service.
- Buildings should be retrofitted with central air conditioning.
- A cosmetic upgrade may be necessary so the building’s exterior is comparable to nearby buildings.
The following example illustrates how critical property owners’ actions can be when requesting financing. When preparing to sell his building, an owner provided the underwriter with an operating statement and rent roll that represented the property as 90 percent occupied. In turn, the underwriter audited 20 percent of the building’s office spaces.
Based upon the preliminary audit, the underwriter determined that more than 18 percent of the property was vacant. Another audit was conducted, and the underwriter asked to see copies of all leases. The leases and second audit revealed 35 percent vacancy, with some of the tenants receiving below-market rent concessions to raise the lease number.
When this information was presented to the landlord/owner, he withdrew his offer to sell the building and hoped to avoid a lawsuit. If the owner had worked with a qualified commercial real estate professional, this situation could have been managed more effectively.
If real estate brokers are aware of lenders’ financing criteria, they can guide building owners and managers to eliminate red flags and overcome potential obstacles. By understanding a property’s essential information including operating expenses, capital expenses, income stream, the length, number, and content of all leases, and the occupancy rate, brokers can play a pivotal role in helping to close deals.