Definitions and Terminology
Capitalization rate: Your capitalization rate is your net operating income divided by the sales price. Also known as the cap rate, it's the measure of profitability of an investment. Cap rates tell you how much you'd make on an investment if you paid cash for it; financing and taxation aren't included:
Cap rate = net operating income ÷ sales price
Cash flow: Your annual cash flow is net operating income minus debt service. You can also figure monthly cash flow by dividing your annual cash flow by 12:
Annual cash flow = net operating income – debt service
Monthly cash flow = annual cash flow ÷ 12
Cash-on-cash return: To find your cash-on-cash return, divide your annual cash flow by the down payment amount:
Cash-on-cash return = annual cash flow ÷ down payment
Debt service: Debt service is calculated by multiplying your monthly mortgage amount by 12 months:
Debt service = monthly mortgage amount x 12
Effective gross income: You can find your effective gross income by subtracting vacancy from gross income:
Effective gross income = income – (vacancy rate % x income)
Gross income: Gross income is all of your income, including rents, laundry or vending machine income, and late fees. It can be monthly or annual.
Net operating income (NOI): Your net operating income is your effective gross income minus operating expenses:
Net operating income = effective gross income – operating expenses
Operating expenses: Your annual operating expenses of the property typically includes taxes, insurance, utilities, management fees, payroll, landscaping, maintenance, supplies, and repairs. This category doesn't include mortgage payments or interest expense.
Vacancy: A vacancy is any unit that's left unoccupied and isn't producing income. Remember: A unit that's vacated and re-rented in the same month isn't considered a vacancy; it's considered a turnover.
Vacancy rate: Your vacancy rate is the number of vacancies divided by the number of units:
Vacancy rate = number of vacancies ÷ number of units
Gross lease: The landlord agrees to pay all operating expenses and charges the tenant a rent that's over and above the operating expenses. The types of expenses covered include taxes, insurance, management, maintenance, and any other costs associated with operating the property.
Modified gross lease: This lease is slightly different from the standard gross lease in that some of the operating expenses – such as maintenance, insurance, or utilities – aren't paid for by the landlord and are passed on to the tenant. These expenses are called pass-through expenses because they're passed through the tenant. Many office-type buildings use a modified gross lease.
Net lease: In a net lease, the tenants pay the operating the expenses of the property and the landlord gets to net a certain amount every month by charging rent over and above the total operating expenses. This lease is favorable in many ways: It's favorable to the landlord because she isn't responsible for any operational expenses of the property. It's favorable to the tenant because he gets to fix up his store as he sees fit and do his own maintenance and cleaning. Net leases are typically customized to fit tenant needs.
This type of lease is used mainly by retailers. The landlord takes care of the common area maintenance, and the expense of that is spread among the tenants and billed back to them.
There are several different levels and types of net leases:
Single net lease (N): In a single net lease, the tenant agrees to pay property taxes. The landlord pays for all other expenses in the operation.
Double net lease (NN): In a double net lease, the tenant agrees to pay property taxes and insurance. The landlord pays for all other expenses in the operation.
Triple net lease (NNN): A triple net lease is most favorable for landlords and is one of the most popular today. The tenants agree to pay the landlord rent plus all other property-related expenses including taxes, insurance, and maintenance. The landlord gets a true net payment. Banks, fast-food restaurants, and anchor tenants typically use triple net leases.
Myths and Questions About Investing in Commercial Real Estate
- You must start off in residential real estate to get into commercial real estate. There's no rule, rhyme, or reason stating that you must first invest in residential real estate in order to make the leap into commercial real estate investing. These fields are two different animals, two different languages, and two different consumers. It's like comparing apples to oranges.
- Only the rich need apply. As you can probably imagine, this myth is just that: a myth. It isn't true that you have to be rich to get involved with commercial real estate investing. You can be as creative in your financing here as you can be when investing in homes.If you don't believe us, here's an example: Donald, a mentoring student of ours, recently purchased a 24-unit apartment building. The purchase price was $750,000. The owner carried a second mortgage of $100,000 for Donald. That left him $50,000 for a down payment. Donald negotiated $30,000 for repair credits at closing. That left him with an out-of-pocket cost of $20,000, he funded from a refinance from another property. Donald proves you only need to be rich in desire and creativity.
- This game is only for big-time players. In commercial real estate it doesn't matter where you start, and it doesn't matter if you only want to devote part of your time to do it. Having a full-time job or being a single-parent doesn't matter either.
- Co-author Peter Harris started his career by buying small commercial properties. His first was a cheap seven-unit apartment building. His second was a small and quaint self-storage building used by the plumbers in town. He did this part time while holding a full-time day job and raising a small family. It all started from here and grew to owning and operating large community properties around the country.
- Commercial real estate investing is riskier. To this we say, "Compared to what?" If you compare it to stocks, do you have control over the companies you own stock in – in areas such as income, expense, debt, management, and insurance? We bet not. However, you do have these five controls in commercial real estate investing. If you compare it to residential real estate investing, what happens if you rent out your single-family home and the tenant moves out? What's your monthly income then? The answer: Nada. If, on the other hand, you own a 24-unit apartment building and one tenant moves out, what's your monthly income? Answer: 23 paying tenants worth of rent! What's more risky? We rest our case.
- Commercial real estate is too complex for simple folks. Again, this isn't true. Remember when you got your new PDA cellphone? You had no idea how to use it. It seemed too complicated, and it had entirely too many buttons. But there was a manual to get you started. After that, through repetition and practice, what seemed much like a puzzle is now fully understood and appropriately used. Getting to know commercial real estate investing the same concept. You have quite a few things to master, but it isn't rocket science. We have taken students from knowing nothing to making offers in a few weeks. They're walking proof that it can be done.
Increasing Your Chance of Getting Your Offer Accepted
The best investors have discovered that they must conserve their time and energy when looking at properties and making offers. If you aren't careful you can waste all your time on deals that aren't worth buying. So, follow these three rules to increase your chances of getting an offer accepted:
- Use a qualifying system so that you're focusing only on the leads that have a high probability of turning into deals.
- Know the strategies that will make a deal work and direct the negotiation toward a winning deal right from the start.
- Use a systematic method to negotiate and put the deal together instead of relying on gut feelings or some other non-repeatable process.
What is Due Diligence?
Due diligence is the process of "doing your homework" on the property that you're thinking about buying as an investment. It's the process of checking, double-checking, and confirming any important information that was used to determine whether the property is a good, average, or bad deal.
Proper due diligence takes persistence and weeks to accomplish. And remember that due diligence isn't used as an excuse to back out of the deal; it's primarily a means to protect you financially and legally. In your typical purchase contract, you find a clause that says either "due diligence period" or "inspection period." What property items you'll be able to inspect and how many days of due diligence you have are stated in that contract clause as well.
During this time, you want to verify many different pieces of information, including the following:
- Rents, leases, and any other income
- Any and all expenses related to the property
- Any defects in the physical condition of the property's interior and exterior
- Possible environmental problems on or surrounding the property
- Any service and vendor contracts
- Existing warranties
- Local police reports
- Any liens placed against the property, such as loans, back taxes, or judgments or anything else that stands in the way of transferring ownership.
- If, after digging into all this information, you find something wrong with the property, you should go back to the owner and renegotiate.
There's usually no charge for you to perform due diligence, but you'll likely have to hire either a professional inspection company or an accountant (or maybe both), and this expense can run several thousands of dollars.
Physical Due Diligence Checklist
When investors think of physical due diligence, they often only think of an actual walk-through of the property with an inspector. Walk-throughs are a part of physical due diligence, but only a tiny part of it. You have quite a bit more to think about and do. For instance, ask the seller for the following items:
- Site plans and specifications: This group of documents includes all the construction documents, building plans and schematics, floor plans, and land use documents. These docs provide a road map of the property's inspection for when it was first built, how it was built, and for what purpose.
- Photos of the property: Photos of the exteriors, interiors, and the surrounding land and structures should be taken. Digital aerial photography is widely available and aids in showing the placement of the property within neighborhoods and in between highways. Having photos allows you to start putting together the pieces of the puzzle and knowing what's in your vicinity can only help you in determining what obstacles you may be facing now or in the future.
- A structural inspection: Inspect the walls, roofs, and foundation, and make sure there are implements in place for earthquake safety. This inspection counts as the exterior and interior inspection. Allow a professional inspection company to guide you in this inspection.
- An interior systems inspection: Inspect the interior of the property for wear and tear, including items such as doors, doorways, windows, and weatherproofing. Then inquire about the age of the roof, any building code violations, government compliance (such as physically impaired requirements), and site improvements.
- A mechanical and electrical inspection: Make sure that every mechanical and electrical system is inspected. Such systems include heating, ventilation, air conditioning, plumbing systems, and all electrical power systems and controls.
- A list of capital improvements performed: Obtain receipts and documentation of any capital improvements that were made over the last five years. This documentation will help with the clarity and assessment of the physical inspection and allow you to project when parts of the property may need repairing or replacement within the next few years.
- A pest inspection: On some types of buildings, an inspection for pests, such as termites, may take place. Most apartment buildings have this inspection done as part of a lender requirement. If termites are found, the building is chemically treated.
Financial Due Diligence Checklist
The financial aspect of due diligence focuses on why you're buying the property. It helps ensure that you make money by verifying the seller records of the property's financial performance. To perform thorough financial due diligence, be sure to obtain the following from the seller:
- Income and expense statements: These statements show what the seller has collected in income from the tenants as well as what the owner spent in operating the property. You should at least obtain annual income and expense statements for the past three years. Also, get all of last year's monthly profit and loss statements and review the balance sheet for the past three years. These documents can be obtained from the seller. After you have all this information, complete your financial evaluation on the property to ensure that it produces the type of returns that you expect or desire.
- Rent rolls: A rent roll is essentially an attendance sheet for all the tenants. It displays the tenant name, unit space or square footage, amount of rent paid, move-in date, lease expiration date, and security deposit. When you have the rent roll, verify the rent amounts with those given on the lease agreements. Also, add the total income of the rent rolls and compare that with the income and expense statements amount. If you notice any discrepancy here, put up a red flag and investigate further.
- Tax returns: Obtain the property's tax returns for the past three years. If there's a single owner, you only need to review that return. If the property is operating under a partnership agreement, you need to get every partner's tax return for the property. Add up all the income and expenses shown on the tax returns. These numbers should match those from the property's income and expense statements. If they don't, ask yourself a question: "Which would you believe? The IRS tax returns or documents that the seller produced?" Crunch your numbers again and see if the property still produces an acceptable return for you. If the discrepancy is in your favor, that's okay, but if it's not, you may have to renegotiate the terms of the deal to meet your objectives.
- Lease agreements: A lease agreement can be a complex legal document. We suggest allowing someone who has expertise with that type of lease do the auditing for you. If all the leases are the same, such as in an apartment building, have an attorney review the first few to make sure that they're valid. For every other category of commercial real estate, we suggest verifying the leases by using an estoppel letter. This letter confirms that the lease is true and accurate and is the only agreement that's made between the tenant and the owner.
- Utility bills: Obtain the past two years' worth of actual utility bills for the property. These bills include electricity, gas, water, sewer, trash, telephone, cable, and Internet service bills. Compare the totals of each utility category to the seller's total given on the expense statements. If the numbers don't match, put up a red flag. Reevaluate the numbers and see if the deal is still worth making.
- Property tax bills: Obtain the past two years' worth of property tax bills. Verify the amounts with those given on the seller's expense statements. Again, if the numbers don't match, put up a red flag and investigate the discrepancy. Reevaluate to see if it's still a good deal. Also, call the tax assessor's office and find out how the property will be reassessed and how often after you become the owner. It's a good idea to figure this property tax increase into your expense calculations as the new owner. It also varies from state to state. For example, in California the tax rate is roughly 1 percent of the sales price, but in Texas, the tax rate is about 3 percent of 80 percent of the purchase price.
Legal Due Diligence Checklist
Legal due diligence can be pretty extensive, and checking on the items in this list take a team effort. But, from experience, we know that it gets easier as you go. When you begin to understand the importance of the many documents and the ins and outs of each, you can cut to the chase really quickly. Here are the items that you need to ask the seller for:
- An environmental inspection: The environmental inspection most often used is called a Phase I Environmental Site Assessment. During this inspection, the inspector explores the past use of the property and the surrounding area, looking for onsite and offsite environmental problems and liabilities. Phase I reports cost in the thousands of dollars and are very involved timewise, so plan ahead if you want one or if the lender requires one. Keep in mind that every seller won't necessarily have one lying around either.
- A survey and title inspection: With this inspection, a title company can verify the property size and that the title report has the same description as the survey. With this inspection you'll also review any liens, judgments, easements, or encroachments on the property that could drastically affect its value and use. If the title has any issues, it must be delivered "clear" by the seller before closing.
- An inspection for building code violations: Some of the most common violations you might run into with this inspection include unauthorized construction, non-city approved improvements, or substandard electrical or plumbing work. If a violation occurs after a building is built, it may be considered a nonconforming use and is considered to be grandfathered in. Going to the city's planning department's records will clarify this.
- The zoning code: Every property has a specific use permitted. For example, a property can be zoned as residential or commercial. So, you need to review the city's zoning ordinances to make sure that the property's use complies with what it's legally zoned for. If it's used illegally, the property can be shut down. Lenders will not loan on a property that's being used for what it's not permitted for.
The insurance policy: The property's insurance policy can be a treasure trove of information if you can get the claim history. The property's claim history will tell you if the property has experienced fires, flooding, lapses in coverage, or policy cancellations.
- Licenses, permits, or certificates: Some of these items are necessary to operate a business, so make sure to get them from the seller. If not, check with the city to see what's required to operate your property. Oftentimes you're required to post business licenses, permits, or certificates. Make sure that you're proactive in notification of new ownership to avoid hefty fines.
- Service and vendor contracts: Review all service and vendor contracts to make sure that you have the right to choose or discontinue the services. These types of services may include, among others, maintenance, landscaping, or laundry. Review and keep records of any equipment warranties and guarantees.
- A personal property inventory: Obtain a list of all personal property items, such as equipment, tools, computers, furniture, supplies, and appliances that are to remain behind with you, the new owner. Document all these personal items in writing or consider them gone. In most transactions, you use a Bill of Sale form to document the personal property items to be transferred. Check your purchase contract as to how personal items are accounted for and transferred.
- Any police reports: Determine past and current police reports by calling the local police department. Review the type and frequency of calls to the property. Know what's going on before you buy.
Get a Title Commitment
The title of a property is the legal evidence of rightful ownership and is given in the form of a deed. So, after you have opened an escrow, the escrow or title company officer will order you a preliminary title report. Preliminary reports are thorough evaluations of public records of the ownership chain or "chain of title" for the property. They're based on information that has been gathered by the title company over the course of many years. You can expect to receive your report within three to five days.
In this report, you find the general history of the property's ownership as well as loans, liens, or encumbrances placed on the property by other parties. If the title has problems, it can't be transferred to you at closing. In other words, each title problem must be resolved by the seller and escrow company before closing can occur. So it's important to order and review the preliminary title report early, because the owner then has time to take care of the problems while everyone works toward closing.
Get a Preliminary Title Report
Here are some red flags to watch for on your preliminary title reports:
- Improper authorization: Make sure that the person who signed on the contract is authorized to do so and has the ability to actually sell the property to you. In other words, make sure that the person who signed the contract is the owner or can verify that he represents the owner.
- Unsatisfied mortgages: An unsatisfied mortgage can occur either because the seller has an outstanding mortgage on the property or because a previous mortgage wasn't recorded properly as paid and then removed.
- Property tax liens: If a seller is behind on paying the property real estate taxes, we suggest you arrange for the owner to pay them before closing or renegotiate the terms of the deal, especially if you end up paying for them.
- Mechanics liens: In the case of mechanics liens, the seller didn't pay for contractor services performed on the property, so the contractor has a lien against the property for payment.
- Judgment liens: If you come across a judgment lien, you know that the seller has been a party to a lawsuit and a judgment has been awarded against him and the property.
- Leases: Here the seller is under a lease agreement for either equipment or a service and the property is used as security for the lease.
- Easements: If the seller has easements, that means he's granted the right to use another person's land for a stated purpose, such as the right to travel across a property owned by another person. This becomes a red flag to new owners who thought they could use the property exclusively for themselves.
You Found Problems, What Now?
Okay, so you've done your due diligence and you have all the reports in front of you. Take a deep breath because this is the part where surprises always seem to come up. The first question to ask yourself is this: "If I already owned the property would this be a big problem or a minor annoyance?" The biggest challenge all of us face is that we're too close to the deal. We can't keep ourselves from thinking about the thousands of dollars we're going to make on the property we haven't even bought yet.
To figure out how to proceed, as best you can, (and it isn't going to be easy to do), answer this question: "If I saw this deal today, and knowing everything that I know at this point, how much would the property be worth to me?"
You may have such a great deal that the problems you've uncovered really don't matter. The property is still worth buying even if you can't or don't want to renegotiate further with the seller. (We tend to renegotiate anyway. But then again we think it's fun!)
- If the problems are serious enough that your current price and terms with the seller no longer make sense, you can walk away from the deal or renegotiate.
- If you're already going to walk away from a deal, why not take the extra step of renegotiating with the seller-just for the fun of it. The worst case scenario is that you end up losing the deal (which you've already decided to walk away from anyway).
Closing the Deal
Q: What's the difference between closing on a single-family residence and closing on an 80,000-square-foot shopping center?
A: Very little. If you've closed on a house, you're familiar with the nuts and bolts of closing your first commercial property. The basics of a residential closing – such as opening an escrow account, handling deposits, dealing with closing costs, obtaining title insurance, transferring titles, and moving buyer and seller monies – also take place with the closing of a commercial property.
The Anatomy of a Close
In order to really understand how a deal gets closed and how you get the keys or a big check at the end, it helps to look at what a commercial deal entails – from the signing of the contract to the closing day. The following big-picture view helps you get a handle on what takes place with the person making the offer, the escrow/title company, the lender, and the attorney:
- The buyer makes an offer to purchase and, if the seller likes the offer, the seller accepts and signs it. Congratulations, you're officially under contract!
- The buyer opens escrow with an escrow/title company or attorney and sends in earnest money as a deposit to the escrow holder.
- The buyer starts the financing process with his lender and sends necessary documents to the lender to qualify both the property and himself (and/or his partners).
- The buyer does his due diligence (such as reviewing the property's financial statements and other property-related information as set forth in the contract) and does a physical inspection of the property.
- The buyer examines the title and removes contract contingencies.
- The buyer and seller satisfy any remaining obligations as set forth in the contract.
- The buyer finalizes the loan with the lender by getting an official letter of commitment from the lender.
- The buyer reviews the closing statement and finalizes any final closing instructions with the escrow company.
- On the closing day, the buyer signs the closing paperwork with the escrow company and makes a down payment.
- The deed is recorded, monies are disbursed, and the buyer gets the keys.
Congratulations, your deal is closed!
What is Title Insurance?
After you have legal title of the property, you're considered the owner. But what happens if the title came to you with a lien against it? What if the liens against the property total thousands of dollars? That's where title insurance comes into play.
Title insurance insures you against such things as liens, undiscovered liens, improper recording of deeds, and other things that could negatively affect the title. The protection period of the title insurance extends backward, which means that it insures you against losses from the past ownerships of the property. And the insurance is in effect as long as you own the property.
If the person you're buying from already has title insurance, you can't have the current owner transfer his title insurance to you, even if it's brand new. You have to buy title insurance yourself. Who pays for the cost of title insurance, the buyer or seller, it depends on what's customary for that city.
Some lenders give you a choice of whether to buy title insurance. We recommend that you buy title insurance even if you're sure there's nothing wrong with the title. Some title problems can be so bad that they can cause the title to be deemed "unmarketable." This kind of situation is exactly what title insurance protects you against. Some people think that if they paid cash for the property, they don't need title insurance. Just because you have a grant deed with your name on it doesn't mean that you have clear title.
Do I Need an Attorney for my closing?
All of our East Coast closings were completed through a real estate attorney. On the other hand, all of our West Coast closings were done by escrow/title companies. So whether you need an attorney for your closing depends on where your property is located. Look and see what is customary in your state or city by asking an experienced local real estate agent.
Attorneys commonly handle commercial real estate closings. And having the help of an attorney is advantageous, because so many things can go wrong during a closing. With all the complex language that's used in closing paperwork, an attorney can help you wade through it all.
When you hire an attorney to step into the shoes of an escrow company, the attorney will do the traditional escrow company duties, plus they'll also:
- Coordinate the closing date and help keep the buyer and seller sides and the lender on track
- Help review all documents for accuracy
- Personally attend the closing
- Write up any needed contract amendments
Do Closing Costs Differ in Commercial Real Estate?
Folks always want to know whether closing costs are an issue in commercial real estate (just as they are in residential real estate). The quick answer is yes. And there are two main reasons for this:
- Typically, commercial real estate deals are bigger than residential single-family deals. The fees that are calculated based on the size of the deal, such as title insurance, are larger in scale.
- Commercial closing involves a few more third-party costs that are larger. For example, a new survey generated on a single-family property could cost a few hundred dollars and is only necessary if a lender requires it. For a large apartment complex, however, the survey could cost tens of thousands of dollars, and commercial lenders nearly always require a survey. Similarly, an appraisal report for a single-family home will cost around $500 and take one week to deliver, but for a shopping center, it may easily cost $5,000 and typically take three to four weeks to deliver.
As a general rule, you can expect commercial closing costs to be about 3 percent of the purchase price. This figure is just a quick estimate, though. If you want a more specific figure, call an escrow company and ask for the typical closing costs incurred. Note: You'll have to give the escrow company a purchase price, or at least an estimation of a purchase price, in order to receive an estimate.
Is it Better to Close at the End or the Beginning of the Month?
If we had to name one real estate question that starts bar fights, this is it! We don't want to start a fight, so we make the case for both and let you decide which one is most beneficial for your unique situation.
For the most part, the choice comes down to reducing your out-of-pocket costs at closing by paying less in prepaid interest on your mortgage. Or you can get credited for almost a full month's rent at closing. Your choice.
Here's an example to guide you: If you close on June 2, for example, you prepay 28 days of interest to cover June's interest. In this case, you have to bring more cash to the closing than if you had closed three days earlier, on May 31. And your first mortgage payment would be due August 1. Your August 1 payment includes the interest payment for July. On the other hand, you would also receive 28 days of rent (prorated and credited to you at closing), plus all of July's rent without having to make a mortgage payment in July.
If you close on June 29 instead, you prepay one day of interest to cover the last day in June. Your first mortgage payment would be due August 1. Your first mortgage payment includes the interest payment for July. The main benefit is that you minimized out-of-pocket costs at closing. Of course, this helps investors who are coming close to running out of cash after closing. You would also receive July's rental income without having to make a mortgage payment in July.
What's on a Closing Statement?
The document at the center of the transaction of closing is the final closing statement, which is also called the HUD-1 settlement statement. The closing statement is important, so in this section we explain what's on it.
The closing statement for commercial real estate is the same form that's used in closing residential single-family home transactions. It lays out the charges in getting the transaction closed (see the earlier section "The closing instructions and closing statement" for a list of charges you might see on a closing statement). The amounts shown on the HUD-1 statement are final when agreed on and signed by the buyer and seller.
Sections A through I: General Information
Sections A through I show basic information, such as the loan type, the borrower information, the lender information, the location of the property, the closing office information, and the close date.
Section J: Summary of Borrower's Transaction
Section J shows the borrower's specific settlement charges. Here's how the section is broken up:
- Line 100: Gross Amount Due from Borrower: Line 120 totals the cumulative total of the purchase price plus total closing fees.
- Line 200: Amounts Paid By or on Behalf of Borrow: Line 220 totals the amount needed to satisfy the transaction, such as the new loan, the earnest deposit, the down payment, taxes, and any amounts the seller owes the buyer (such as repairs and so on).
- Line 300: Cash at Settlement from/to Borrower: Line 303 totals the amount of cash the buyer needs to bring to the closing.
Section K: Summary of Seller's Transaction
This section shows the total amount due to the seller. Here's what the one line number in this section looks like:
- Line 400: Gross Amount Due to Seller: Line 420 totals the purchase price plus any adjustments for prepaid taxes or unpaid taxes.
Section L: Settlement Charges
Section L basically breaks down all the fees and amounts, referred to as "settlement charges," that the buyer and seller are responsible for. Here's how the section is broken up:
- Line 700: Total Sales/Broker's Commission Based on Price: The commission charged by the real estate broker for services
- Line 800: Items Payable in Connection with Loan: The loan origination fee, any discount points paid to reduce the mortgage rate, the appraisal fee, the credit report fee, and the application fee for mortgage insurance
- Line 900: Items Required by Lender to Be Paid in Advance: The interest on the loan for the period before the first monthly payment, and the initial mortgage insurance and hazard insurance premiums for 12 months
- Line 1000: Reserves Deposited with Lender: Escrow items that the lender holds to cover future expenses, such as property taxes and annual assessments
- Line 1100: Title Charges: Costs of changing ownership of the property, such as the settlement or closing fee, title examination fee, and attorney's fee
- Line 1200: Government Recording and Transfer Charges: City, county, and state taxes or stamps needed to transfer ownership
- Line 1300: Additional Settlement Charges: Surveys and inspections (for pests and lead-based paint, for example)
- Line 1400: Total Settlement Charges: Sum total of all the previously listed fees
Financing and Lending
What Lenders Don't Like in a Deal
Lenders are people too, don't forget. They have feelings, and they have things that they like and get excited about just as the rest of us do. So, when lenders evaluate your deals, give them things that they can be excited about. Keep in mind that the good-deal points can actually sometimes overshadow some of the bad-deal points.
Here are a few of those good-deal points that lenders really like to see:
- Cash flow: Properties that have positive cash flow are a lender's delight. Lenders like these properties because they have the extra oomph to overcome problems, such as your low credit score, being in a below-average neighborhood, or having overdue repair needs on the property. Remember the saying, "Cash is king," because it surely applies here.
- A good purchase price: Lenders like it when you buy low. When you buy low, your debt will be low, so your debt coverage ratio will be higher. The higher the debt coverage ratio, the wider the smile on your lender's face (we discuss debt coverage ratio earlier in the chapter).
- Strong operating history: Remember the feeling of bringing home a date that your parents actually liked? Well, if you bring a property to your lender that has been operating really well for the past two or three years (it has experienced stable or increasing income and low vacancy and has been maintained well), you can expect your lender to greet you with open arms-and an open wallet.
Commercial real estate is a business that's based on relationships. More deals and loan approvals are settles because of relationships than anything else. You need to approach the lender with integrity, respect, and honesty. Get the lender to like you by building a solid and friendly rapport as best you can.
Understanding the Available Conventional Loans
Many different types of conventional loans are available for the different types of commercial real estate. Here's a list of the most commonly used loan options and types:
- Long-term loans: These loans can go up to ten years in length at a fixed interest rate. If you don't plan on selling the property for a while, consider a long-term loan. These loans are typically amortized for 30 years.
- Long-term loans have an early payoff penalty, which is called a prepayment penalty or defeasance payment. So, if you commit to a seven-year loan, but want to sell the property in two years, you'll be socked with a substantial penalty for doing so. (See the later section, "Knowing the costs of getting out of a loan," for more details on this early payoff penalty.)
- Short-term loans: These types of loans are usually up to three years in length and typically have lower interest rates than long-term loans. If your investing strategy calls for you to sell the property in three years or less, this may be the loan for you. These loans are amortized for less than 30 years in most cases. Conduit loans: These loans are good for properties that are stable and well established with solid tenants. Interest rates are usually low and fixed with long amortization periods. And remember that these loans can be nonrecourse. Nonrecourse means that the borrower isn't personally guaranteeing the loan. And not being liable for the loan just in case something goes wrong is good for investors.
- U.S. government agency loans: Believe it or not, about 20 percent of all commercial loans given in the United States are somehow tied to the government. For example, the Federal Housing Administration (FHA), Fannie Mae, and the Department of Housing and Development (HUD) are just a few types of government loans available. But keep in mind that these agencies aren't lenders, they're insurers. You must find a government-approved lender who's willing to grant this type of loan. These loans have some of the most favorable terms, such as lower down payments, longer loan terms, up to 40 years of amortization, and lower interest rates.
- Construction loans: These loans tell a story. They tell the story of how you plan to construct a property. If the story isn't a good one, the lender won't lend you the money. It's that simple. These loans are taken out to fund the building of a property to completion or until certain leasing percentages are met. With these loans you usually have a timed payout or a scheduled draw where funds are released for construction as you build. Interest-only payments and loan terms of only one to three years in length are normal.
- Take-out loans: A takeout loan is the loan that comes after your construction financing. It's a permanent loan that goes onto the property. It can be a long-term, short-term, conduit, or government loan.
- Mezzanine loans: These loans combine themselves with permanent or construction loans. Most banks won't exceed 80 percent loan-to-value, and so that's where these loans come in. They stack themselves, hence "mezzanine" on top to achieve loan-to-values as high as 90 percent financing. Large projects, such as skyscrapers and large shopping centers, which cost tens to hundreds of millions of dollars, use mezzanine financing. One important characteristic of this type of loan is that it's secured not by a mortgage or deed of trust, but by holding a security agreement against the owner's stock in the LLC. If the owner defaults on the loan, the lender takes the stock that owns the building.
- Bridge loans: These loans are sometimes referred to as gap financing or opportunity loans. Short-term financing is used to bridge the gap between finding a permanent loan and actually closing on a permanent loan. These loans are useful in funding deals quickly, but they can be costly due to their effectiveness in allowing you to capitalize on a deal that you otherwise wouldn't have been able to.
- Small Business Administration (SBA) loans: If you plan to occupy at least 51 percent of the property yourself, check out an SBA loan. With these loans, a down payment that's as little as 10 percent is possible if you have a stable property. Another benefit is that the interest rates will be lower than a conventional loan. You can also use this type of loan as a construction loan if you plan to occupy at least 60 percent of the property. But remember the SBA loans aren't made by the Small Business Administration – it merely insures the loans. So, you have to go to an SBA-approved lender to actually receive the loan.
- Stated income/no documentation loans: If you have no job, but you have a home with equity and good credit, getting a loan for your commercial property is still possible. Stated income and no documentation loans (also called no doc loans) don't require borrowers to show proof of monthly income or income tax returns. However, the property must have a high cash flow and be in excellent condition. In the right condition, 85 percent loan-to-value is possible.
- Hard money loans: If you have bad credit, had a recent bankruptcy, or the property needs to close in a few weeks, you can use a hard money loan. These lenders usually require a hefty down payment (35 percent or more), and have exceptionally high interest rates (12 percent to 18 percent), and three to ten points. However if you find a deal of a lifetime, have no time left on the clock, and need money yesterday, this may be the way to go.