Making the Case for Your Commercial Refinance, Part 1

Since we released the original version of our Real Estate Investment Analysis software in 1982, our focus has been on pro forma financial analysis of real estate investments and of development properties – projecting the numbers out over time to help users gain a sense of what kind of investment performance they might expect from a particular property or project.

And for lo, these many years, our customers (and from time to time, we ourselves) have used the software to help make decisions as to whether or not to buy a property, and at what price and on what terms. Customers have used it to model how things might play out in the worst case, or in the best case, or somewhere in between. They have used it also to compare alternative investment opportunities.

This type of decision-making process has by far been the most common use of our software. More and more, however, we’ve seen an increased use of these pro formas for the purpose of making presentations to potential equity partners and to lenders.

Which brings us at last to the point of this article. When the economy is blazing away at warp speed, everything is – or at least seems – a bit easier. Forecasts are easier to meet, and partners and lenders are easier to find. But sometimes the economy is not so good, and presents us with new challenges. At this writing, we find ourselves in the middle of a bad case of credit lockjaw. Nothing lasts forever (which in this instance is a good thing), so eventually our credit markets and overall economy will rediscover their equilibrium.

This is all fine, unless you’re holding a property today with a mortgage that will balloon in the near future. In that case, you need to find a new loan, and you’re probably going to have to work for it. That means doing some homework, understanding the process, and building the most compelling case you can for approval of that new loan.

If you were trying to refinance your home, you would be dealing with recent sales of comparable houses, your personal income and debt, and your credit score. With the possible exception of working to get your credit report in order, there’s not a great deal you would do personally to build a case for your re-fi. With an income property, however, a carefully prepared presentation can go a long way in helping you convince a lender – or even a new equity partner – that you have a viable investment.

Re-enter your friend, the pro forma analysis. You may have thought he was on vacation until sales of real estate revived, but in fact he’s as busy as ever with financing and partnerships. If the numbers do indeed work for a property whose balloon is coming due – and sorry, don’t expect to transform a bad investment into a good one with just a pile of color charts – then a detailed pro forma may be that property’s best friend.

Don’t even think about starting that pro forma until you’ve done a bit of legwork and preparation. First you’re going to need some information that is external to the property itself. You need to know the prevailing market capitalization rate for properties of the same type as yours (i.e., office, retail, apartment, industrial, etc.) and in the same market. This information will be critical to estimating the current value of the property. Perhaps the best place to seek this information is from a local commercial appraiser. The bank will certainly use an appraiser, and the appraiser will certainly use a cap rate, so don’t get left out of the party. For the sake of the example we’re going to construct here, say that the commercial appraiser tells you the prevailing cap rate for properties like yours in your market is 11%.

Next you need to learn about underwriting criteria from your potential lenders. Specifically, you need to know the probable interest rate and term of the new loan; the lender’s maximum Loan-to-Value Ratio; and the lender’s minimum required Debt Coverage Ratio. Don’t assume that these criteria will be identical across all lenders or across all property types. In fact, they probably will not. It should not surprise you that different lenders quote different interest rates, but you must also recognize that the same lender may be willing to lend 80% of the value of an apartment complex, but only 65% of the value of a shopping center. Know the lender’s terms before you ask for the loan.

For the purpose of this example, let’s say you’ve called your current lender and found that their maximum Loan-to-Value Ratio for a property like yours is 75%. They require a Debt Coverage Ratio of at least 1.20, and if all looks good, they will loan at 7.75% for 15 years.

We’ll discuss these criteria in detail in a moment, but for now let’s stay focused on collecting information, this time about the property itself. You need to assemble the amount of actual current rent income from each unit and identify the market rent of currently vacant units. You need to make realistic estimates of rental income for the next several years, taking into account the terms of leases now in place. You must figure your current year’s operating expenses, keeping in mind that certain expenditures such as debt payments, capital improvements and commissions should not be included. Nor should you include depreciation or amortization of loan points, which are deductions but not operating expenses. Once again, you have to make some realistic estimates as to how these expenses may change over the next several years. Finally, of course, you have to learn the balance of your current mortgage, so you’ll know how much of a re-fi you require.

Let’s return now to the underwriting criteria you identified, and start with the Loan-to-Value Ratio (LTV):

Loan-to-Value Ratio = Loan Amount / Lesser of Property’s Appraised Amount or Actual Selling Price

If this is a re-fi, then there is no “selling price,” so the value here will be the amount for which the property is appraised. If your financial institution has not taken leave of its senses (in general, if it has not appeared in the headlines or before a Congressional subcommittee in the last six months), then it should be reluctant to loan you or anyone else 100% of the value of a property. They expect you to have some skin in the game, and the question is merely how much.

The lender will quote you their maximum LTV, and before you get anywhere near an application form, you are going to perform your own calculation with your particular property. How much of a loan do you need to replace the existing financing, and how does that relate to the current value of the property?

It should be clear enough that the lower your actual LTV, the more likely you are to secure the loan. The lower the LTV, the more you, the borrower have to lose and the less likely you are to walk away. A low LTV may even earn you more favorable terms. You know how much of a loan you need, so to determine the LTV of your proposed loan, you must estimate the value of the property. Find that value with the same method the lender’s appraiser is likely to use: by applying a capitalization rate to the Net Operating Income (NOI). You already called around to find the prevailing market cap rate, so now you need to calculate the NOI. The most direct way to do this is with the venerable APOD form, where you list your annual income and expenses: