These skills enable brokers to estimate and analyze financial performance, return on investment and property value while negotiating deals more effectively. Quick calculations of the net operating income, the capitalization rate or the debt-service-coverage ratio, for instance, will enable the mortgage broker to demonstrate a higher level of professionalism to a potential client.

“There are about 25 commonly used financial ratios. Several of these are regularly employed when analyzing the performance of a potential commercial real estate investment.”

While these skills may be rudimentary for veterans of commercial real estate finance, those who are new to the business — or even a residential mortgage originator who dabbles in commercial deals — will need to immerse themselves in the basics. A solid grasp of accounting is useful when participating in this field.

Investment analysis

At the heart of financial analysis is an understanding of the financial ratios that measure the relationship between two or more components in a company’s financial statements. These ratios provide a way to track a property’s performance compared to industry standards, identify potential problems and offer a basic report card on management.

There are about 25 commonly used financial ratios. Several of these are regularly employed when analyzing the performance of a potential commercial real estate investment. The following list of terms is not all-inclusive but offers some key areas that can greatly benefit commercial mortgage brokers in their day-to-day business endeavors.

The objectives of financial statements are to provide information about the fiscal performance and changes in the financial position of an organization. This information is crucial when making business and investment decisions.

Financial information is presented in a standardized manner through a set of accounting rules and standards for financial reporting known as Generally Accepted Accounting Principles (GAAP). Much of the information about a company will be found in three common financial statements: the balance sheet, income statement and statement of cash flow.

Balance-sheet basics

The balance sheet is one of the most essential tools in the analysis process. It provides a detailed report of a company’s assets, liabilities and shareholder equity at a specific time, such as the end of the year.

This statement, however, does not show the trends playing out over a longer period of time. Consequently, the balance sheet should be compared with previous periods. By using financial ratios to examine the balance-sheet information, additional insights can be uncovered about a property’s financial condition.

The balance sheet places assets on the left side of the equation, with liabilities and shareholder equity on the right. The resulting equation is assets = liabilities + equity. The accounting equation can be read as assets – liabilities = equity.

The balance sheet is divided into current assets (converted into cash in one year) and long-term assets (converted into cash beyond one year). The accounts are arranged according to their liquidity and the ease with which the assets can be converted into cash.

A liability is any debt a company is obligated to pay. This may include debts to lenders and suppliers, rent and salaries. Long-term liabilities include the total amount of any debt due beyond one year. This will include all debt that’s amortized over a multiyear period.

Current liabilities include the portion of debt due within the next 12 months. As an example, if a company has nine years left on a mortgage for its office building, one year of this obligation is classified as a current liability and the remaining eight years as a long-term liability.

Digging deeper

Other aspects of the balance sheet include equity, which is the net asset value for the shareholders of a business. Net assets are the total assets minus liabilities.

Don’t overlook the balance-sheet footnotes. These offer information on assets, debts, accounts, contingent liabilities and background details to explain the financial numbers.

“These skills enable brokers to estimate and analyze financial performance, return on investment and property value while negotiating deals more effectively.”

An income statement is another essential part of reporting a company’s financial performance. The income statement shows the total income generated, all related expenses, and the resulting profit or loss during a particular period (such as a month, quarter or year). This statement provides insightful knowledge of a firm’s operations and performance in relation to prior periods and industry peers.

Also crucial is the cash-flow statement, which is a report that reflects the amount of cash a company generates from its ongoing operations. It might be the most valuable of all statements since it tracks cash flow through the business in three key ways: operations, investments and financing.

Measuring profitability

A key financial metric used to measure the profitability of an investment property is net operating income (NOI). It represents the income generated by the property after the operating expenses are subtracted. To calculate NOI for commercial real estate, subtract the property’s operating expenses from its gross rental income.

Operating expenses include property taxes, insurance, maintenance, repairs, utilities and property management fees. NOI is used by lenders to determine the maximum loan amount they’ll approve based on the property’s income-generating capacity. (In equation form, NOI = gross rental income – operating expenses.)

The debt-service-coverage ratio (DSCR) measures the cash flow available to service the property’s debt. It is calculated by dividing NOI by the annual debt-service payments. A property with NOI of $750,000 per year and debt service of $600,000 per year has a ratio of 1.25 (DSCR = net operating income / total debt service).

A DSCR of 1.0 means the property generates enough income to cover its debt obligation. A ratio of 1.25 or higher is normally considered an adequate ratio for commercial real estate investments.

Measuring risk

A property’s net operating income is also used to determine the capitalization rate, or cap rate, which measures the anticipated return on a property’s investment income. It is calculated by dividing the property’s NOI by its market value.

Take, for example, an investor who wants to purchase a shopping center that generates $375,000 in net operating income and is valued at $7.5 million. The formula is cap rate = net operating income / property value, which in this example would equal 5%. This means that the property generates a 5% return on investment based on its income.

An investor can also calculate property value based on a desired rate of return. Using a 5% cap rate, the value of the same shopping center can be estimated as follows: value = NOI / cap rate. In this case, the value equates to $7.5 million.

The cap rate is useful for comparing the relative values of different commercial properties. A higher cap rate generally indicates a higher return on investment, but it’s also typically associated with higher risk.

Measuring returns

Two more key terms to remember are return on investment (ROI) and cash-on-cash (CoC) return. ROI is used to measure the profitability of an investment. It is determined by dividing the net income by the total amount invested. The higher the ROI, the better the deal for the owner.

Finally, to measure the cash income earned from invested capital, a broker can use the cash-on-cash return. CoC is calculated by dividing a property’s annual pretax cash flow by the total cash invested.

For instance, let’s say an apartment building costs $7 million with a $1 million downpayment. The building generates $150,000 in annual pretax revenue, so the CoC return is $150,000 divided by $1 million, which equals 15%.

The CoC return means that the cash income earned on the building is 15% per year. Once again, the higher the return, the better the investment.

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The various ratios discussed here are important tools for analyzing the financial performance of commercial real estate. Like all tools, however, there are limitations. They are often based on past performance, may lack comparable data and may not offer enough information to identify an emerging trend. They also don’t reveal all of the relevant information about a company’s past, present or future.

Successful commercial mortgage brokers will use these tools and more to analyze a client’s investment prospects. Brokers need to understand a property’s history and be able to speak the language of financial analysis in the business environment. In other words, to know your numbers is to know your business. ●

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It’s important to note that these economic factors are interrelated and may vary across different regions of the country. Consequently, it’s essential for the commercial mortgage broker to stay abreast of economic indicators and trends that drive loan demand.

“To find a solution that does not include bankruptcy or foreclosure, both the borrower and the lender must establish open and transparent lines of communication.”

It is paramount for the mortgage broker to understand the factors that impact commercial property prices. By untangling these key influences, brokers will gain important insights into what shapes a property’s worth, which enables them to make informed choices that match up with the financial goals of the borrower and lender.

The factors that tend to be most important to brokers and borrowers include the state of the economy, the inflation rate, interest rate trends, and the availability of debt and equity capital. Other factors to keep in mind include the property’s location, its condition, and the number of active investors and speculators in the market.

Key influences

Without question, the two major influences on the current market are inflation and the Federal Reserve’s ongoing interest rate hikes. Beginning in the spring of 2022, the Federal Open Market Committee (FOMC) raised interest rates 11 times in a 17-month period in an attempt to corral inflation back to its target of 2%.

The consumer price index, however, stayed stubbornly high this past September at 3.7%, making it appear that the Fed has more work to do. The FOMC held the federal funds rate steady that month, but Fed Chairman Jerome Powell emphasized that it’s too early to claim victory and that officials are prepared to raise the benchmark rate further, if necessary.

The commercial mortgage markets are also facing a higher degree of ambiguity as economic uncertainty continues to restrain them. Many financial institutions are expected to face major challenges for the foreseeable future, driven by slow or potentially negative growth rates, high inflation and further increases in interest rates.

In addition, underwriting standards are tightening. According to the Fed’s Senior Loan Officer Opinion Survey for second-quarter 2023, 51% of banks tightened their terms of credit for commercial and industrial loans to medium and large businesses during these three months. That share rose from 46% in the prior quarter. For small businesses, 49% of banks reported that credit terms were stiffer in the second quarter, up from 47% in the previous quarter.

These problems may be exacerbated by the estimated $1.5 trillion in commercial mortgages that are reportedly set to mature in the next two years. As a result of rising interest rates and declines in property values, there are growing concerns that lenders may not be willing to refinance these maturing loans on terms that will enable the borrowers to service the debt on a timely basis.

Tough times

For veteran commercial mortgage brokers, this isn’t the first time facing economic uncertainty, high inflation, interest rate hikes and credit tightening. But this might be the most challenging climate since the Great Recession, when home prices dropped by more than 27% and delinquency rates on subprime loans peaked at 30% in 2010.

After navigating through difficult times in the past, the market will surely recover once again. But this commercial real estate downturn will be costly, many will experience major losses and, unfortunately, there will be litigation and foreclosures.

The current problems are numerous and not easily categorized, but for ease of discussion, let’s focus on a single scenario. Although this may be an overly simplified explanation, there are certain deals that were originally well conceived and seemingly well structured, but because of timing, they may be having difficulties meeting their financial obligations.

Deal with defaults

When a commercial mortgage defaults, it’s crucial for all parties to steer through the situation with great caution. Loans in default are challenging, but with the right approach, it’s possible to mitigate potential losses and find a favorable resolution for all parties involved.

A case in point is a commercial property experiencing growing financial problems due to a decline in occupancy. The property is suffering from a major loss of net operating income (NOI), which will result in a higher capitalization rate and, in turn, will reflect a lower value. Furthermore, the loss of NOI may be so large that the asset can no longer meet its debt-service requirement, resulting in mortgage default and a possible foreclosure.

This would be the worst possible outcome in which everyone loses. Unfortunately, we may see this scenario play out many times in the coming years.

Out of this chaos may come opportunities for experienced and forward-thinking mortgage brokers. By acting as intermediaries, brokers can demonstrate their value by developing creative solutions that benefit all parties. To find a solution that does not include bankruptcy or foreclosure, both the borrower and the lender must establish open and transparent lines of communication. They must provide timely progress reports that will help create a favorable working environment.

The first step in this long process is for all parties to have an in-depth understanding of the economic and social factors that are influencing the market and the financial stability of the asset. This analysis cannot be done in a vacuum. The study must be done within the larger context of the commercial real estate industry, existing economic conditions at the national and local levels, and the financial wherewithal of the borrower.

Know the numbers

The second step is to develop a clear and complete understanding of the current financial condition of the property. All parties must understand the capacity of the borrower and the project at hand — in other words, know the numbers.

To aid in the financial analysis, various financial reports will be needed, including the balance sheet — which reflects the project’s liquidity, valuation and leverage. The income statement — which reflects the gross income, operating expenses and net profit — is also crucial.

Other required financial information includes the net operating income statement, which explains the gross rental income, operating expenses and NOI before debt service. Tax returns show the income, profits, losses, deductions, credits and tax liabilities of the project. Ideally, three years of each statement should be provided.

The purpose of this in-depth analysis is to develop a clear and complete understanding of the asset’s current financial situation. This includes the debt-service-coverage ratio, leverage, liquidity and trend lines of other appropriate financial metrics.

Take action

Once the financial review is complete, a set of action plans and financial pro formas can be developed that are based on how to best prepare for a future that is uncertain at best. A pro forma should be designed to anticipate multiple scenarios, include strategies for each scenario and a determination of whether these strategies can be successfully executed. It should explain how to identify and execute the most likely strategy, and how to rapidly adopt an alternative plan if market forces dictate.

Armed with this essential information, it’s time to make tactical decisions regarding the future of the project. Can the project meet its current debt-service requirement? Probably not, which is why a problem exists. The next logical question is, what is the project’s current debt-service capability?

The existing and projected financials, including the NOI statement, will allow the borrower and lender to identify an appropriate level of repayment based on the project’s current debt-service capacity. Another option, if the lender is receptive, is to decrease the existing interest rate and/or extend the repayment terms. The objective is to keep the loan on active interest accrual, maintaining some level of cash flow to the lender.

A final (and maybe least desirable) option is to place the loan into forbearance. This will temporarily pause payments for a specific period, and it generally means that the loan won’t accrue interest.

The lender may or may not agree to this option. A possible benefit is to allow the borrower sufficient time to regain their financial footing and start a revised repayment plan. In many cases, a lender will grant forbearance to a borrower due to unforeseen financial difficulties. After all, the lender typically doesn’t want to seize the property.

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By working together and exploring possible options, the commercial mortgage broker, borrower and lender may find a mutually beneficial outcome. But they must accept the fact that the parties will probably suffer some level of financial loss. The objective is to minimize the loss and normalize the situation at the earliest possible date. The result must be the best possible solution. ●

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Whether discussing the famous Dutch “tulipmania” of the 1600s, the real estate crisis of 2008 or today’s potential bubble in stocks tied to artificial intelligence, economic bubbles happen for a variety of reasons. Because of that, predicting when the next one will occur is no easy task.  As a commercial mortgage broker or lender, it’s important to have an in-depth understanding of these issues to be prepared for the next bubble.

“The bursting of the U.S. housing bubble in 2008 helped to usher in a financial collapse that had extensive impacts on all sectors of the global economy, including the commercial real estate market.”

What is an economic bubble? Simply put, it’s a portion of an economic cycle that is characterized by a rapid escalation in market value, particularly in the price of assets. This fast inflation is followed by a quick decrease in value that is often referred to as a crash or a burst bubble.

One sign that a bubble may be forming is the accelerated growth in the price of a particular asset. This could include anything from housing prices to tech stocks or even commodities such as oil.

Bubble origins

The bursting of the U.S. housing bubble in 2008 helped to usher in a financial collapse that had extensive impacts on all sectors of the global economy, including the commercial real estate market. The crisis led to a significant reduction in the availability of credit, making it difficult for businesses to obtain financing for most real estate projects. This led to a slowdown in construction and development activities.

The decline in the commercial real estate market forced many businesses to lay off employees or reduce salaries, resulting in a decline in consumer spending. Many companies had to downsize or close their doors, leading to a surplus of vacant commercial properties that subsequently resulted in lower rent prices and lower property values.

Commercial real estate today might be described as having many aspects of a bubble, with some observers speculating that a crash may be coming. One reason for this could be the high cost of both owner-occupied housing and multifamily rental housing.

An economic bubble has many parents, possibly including inadequate industry oversight or fraud. But one of the main factors is speculation. This refers to the act of conducting a financial transaction that has substantial risk of losing value while also holding the expectation of a significant gain.

Not to be confused with investing, speculation plays havoc with the economy in general. It destroys consumer confidence and restricts commercial real estate lending, making it harder and more expensive to obtain a loan. This in turn requires the commercial mortgage broker to be more innovative and develop a more creative business strategy.

An old nemesis

Economic bubbles are nothing new. History is littered with remnants of irrational exuberance followed by price crashes. They have occurred in all types of asset groups, such as equities and debt instruments, commodities and real estate. While there have been many, a few recent bubbles stand out.

• Black Monday. The stock market crash of Oct. 19, 1987, resulted in approximately $500 billion in losses and was caused in part by a strong bull market that was due for a correction.

• Dot-com bubble. This stock market bubble was fueled by skyrocketing values for publicly traded, internet-based startups with no track record. The bubble burst, wiping out many fledgling companies. From March 2000 to October 2002, the tech-heavy Nasdaq composite index fell by 77%.

• Great Recession. One of the most spectacular examples of panic in the global financial markets occurred in the fall of 2008. The bursting of the housing market bubble led to a variety of events, including the collapse of investment banks Bear Stearns and Lehman Brothers. It also resulted in the federal government’s takeover of Fannie Mae and Freddie Mac. The event triggered a decline in U.S. home values of approximately $2.44 trillion.

Looking for signs

While bubbles are somewhat hard to predict, experts have identified some basic stages in the life cycle of a bubble. The following are shortened interpretations of these stages.

Rapid growth. This occurs when investors become infatuated with a new concept, such as emerging technology or a broadly accepted product. Investors are quick to back the latest thing and, in many cases, do so with highly leveraged funds.

Irrational exuberance. Investors demonstrate strong enthusiasm and attraction to a specific asset based on its current high performance without giving thought to its fundamental value. Initially, prices rise slowly but then accelerate as more money flows into the asset. This sets the stage for the boom phase, in which the asset attracts widespread attention and media coverage. The number of investors jumps as caution is thrown to the wind and the asset’s price skyrockets.

Profit taking. A small number of investors recognize the warning signs that the bubble is about to burst. They begin to sell their positions and take profits. Estimating the exact time when a collapse will occur, however, is a difficult process.

Panic. Investors realize too late that it’s time to sell and quickly exit the asset. It may only take a minor event to puncture a bubble. But once it happens, the bubble cannot be inflated again. In the panic stage, asset prices decrease as rapidly as they accelerated. Confronted with margin calls, speculators now want to sell at any price. As supply overcomes demand, asset prices collapse.

Risk management

Although there is no one right or best strategy for commercial mortgage brokers and lenders to deal with a bubble, it is crucial they stay abreast of the market sectors they serve. They should also incorporate a robust risk management policy and financial analysis strategy into the origination process.

Mortgage brokers need to diversify their potential client base and stay informed on their lenders’ changing approval criteria. By adhering to these processes, brokers can stay ahead of the financial curve and avoid the overactive investment sectors that may rapidly evaporate due to a recession, inflation or regulatory changes.

In difficult financial times, brokers should expect to see many changes in underwriting standards, including the frequent use of new or expanded financial covenants. An example of a covenant is when a borrower agrees to maintain a minimum financial ratio, such as working capital, total assets to debt, or debt to equity. Covenants require borrowers to comply with the terms in the loan agreement.

Financial covenants serve as a safety net for the lender. The objective is to reduce the risks associated with the loan. By making it a binding part of the documentation, the lender ensures a greater degree of security.

A risk management strategy involves actions and activities designed to manage risks. It’s about taking steps to reduce or control the likelihood or severity of negative consequences. A risk management strategy is usually based on the principles of identifying all possible risks and their possible causes. This includes evaluating each risk to determine its probability and severity; developing a plan to manage each identified risk; closely monitoring the progress of the plans; and reviewing and revising the plans as necessary.

Finding opportunities

Despite this doom and gloom, there are opportunities for commercial mortgage brokers who closely follow the market and have a thorough understanding of their lenders’ underwriting criteria. It is widely reported that approximately $1.5 trillion in commercial mortgages will need to be refinanced over the next couple of years. This may present a unique set of challenges based on current interest rates, inflation and banks being wary of the level of commercial mortgages in their portfolios.

Mortgage brokers may be able to place these loans with new lenders. Additionally, many of the terms and conditions of existing loans will need to be renegotiated. The new loans will certainly face elevated interest rates, which will place more attention on the borrower’s cash flow and net operating income. New appraisals also may be required to establish current and changing property values.

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Predicting when the next financial bubble will occur is difficult, but originators should closely monitor the industries they serve and be prepared to employ risk management strategies, such as diversification and regular credit monitoring of borrowers. It is important to approach each financial cycle as an opportunity to refine risk management strategies, then strive to create better financial products that can achieve positive results in a variety of scenarios.

Are you ready for the next economic bubble? You should be. Remember, the next one is currently in the making and will occur all too soon. Stay alert, stay sensitive to market changes and be ready to make appropriate changes to your current business strategy. When the next bubble happens, you’ll be glad you did. ●

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Commercial mortgage brokers are expected to have the experience, skill and knowledge to assist in arranging almost any type of business-purpose funding requested by a potential client, including financing the sale of a privately held business. A privately held business is a company that is not publicly traded, which means that the company did not raise capital through the sale of stock via public offering. Privately owned companies include family-owned businesses, sole proprietorships and many other firms of all sizes.

It is essential to remember that most businesses have some level of investment in real estate either through leasehold or fee-simple agreements. The degree of real estate holdings will have a major impact on a company’s valuation and subsequent loan requirements.

“The idea of owning a small business is a common dream for many people with entrepreneurial spirit. But there are many financial issues associated with the acquisition of an existing business.”

Small-business market

One potentially attractive area for mortgage brokers to explore is change-of-ownership loans to small businesses. There are approximately 32.5 million small businesses in the U.S., which represent more than 99% of the nation’s businesses, according to the U.S. Small Business Administration.

The idea of owning a small business is a common dream for many people with entrepreneurial spirit. But there are many financial issues associated with the acquisition of an existing business. Commercial mortgage brokers interested in expanding into these types of transactions should start by developing relationships with business brokers or merger-and-acquisition intermediaries.

These connections will help generate a regular source of new lending opportunities. In many cases, the business owner will require the professional services of a business broker in preparing the business for sale, determining a realistic sales price, marketing the sale and negotiating with potential buyers.

In addition, sales will often require lender financing. This is where the commercial mortgage broker enters the picture. They can place the loan with a lender that understands the intricacies of change-of-ownership deals and has the appetite to fund these types of transactions.

Due diligence

To begin the acquisition process, the prospective buyer and the mortgage broker must conduct due diligence. This includes inquiries as to what services or products the subject business offers, how long the company has been operating and its reputation in the local business community.

A thorough review of the company’s financial statements is necessary to confirm its ability to meet future obligations, including debt service. In addition, the lender must evaluate the probability of maintaining and expanding the level of future earnings, which is the primary source of repayment.

Other areas to investigate include supply chain and staffing issues. For example, a manufacturing firm could be dependent on a specific type of synthetic ingredient that may not always be available. Alternatively, what if it became necessary to transport the synthetic product from a source hundreds of miles away? The potential cost increases would decrease future profits.

Labor is also a foremost area of concern. Are workers voting to unionize in the immediate future? Are key employees willing to stay on with the new owners? These issues affect the sales price and the size of the loan.

Understand goodwill

Corporate financial statements are crucial elements to helping the parties arrive at a logical sales price. The commercial mortgage broker should realize that the final price may account for items known as “blue sky” or “goodwill.” These terms encompass the business’s reputation, its brand recognition, customer and supplier lists, and other factors. The value of goodwill can be calculated, but it doesn’t have collateral value.

Brokers must pay attention to customer relationships. What is the company’s reputation with its existing and potential customers? Is the principal customer related to the present owner? If customer problems exist, posting an “under new management” sign will be inadequate.

Equally important is what creditors (trade suppliers, current bank, etc.) think of the company and its future. The big question here is whether they will continue to extend credit in the future. Again, these issues will affect the sales price and the loan amount.

Seek professional help

When purchasing a company, a buyer may acquire either its assets (consisting of the receivables, inventories, equipment and real estate) or corporate stock. The mortgage broker should thoroughly understand these issues because the method used will likely affect the buyer’s and seller’s tax liability, and thus may impact the purchase price.

The tax implications of buying or selling a business are extremely technical and constantly changing. It is advisable that all parties involved secure professional tax counsel.

If the buyer decides to purchase the assets of a company, both parties may wish to secure legal counsel, which will draft a sales contract that identifies the specific assets being sold and the amount paid for each item. This agreement will provide a foundation for depreciation and potentially the total tax liability. These details also impact the sales price and loan amount.

Additionally, legal counsel may be able to help the buyer avoid any potentially unknown liabilities of the business, including latent legal actions. Finally, the buyer may choose to enter into a noncompete agreement with the seller, in which the buyer pays the seller an additional dollar amount to not open a similar business in the respective trade area.

Drivers of value

Mortgage brokers should keep a wide variety of factors in mind when analyzing the drivers of a property’s value. These include the business location, its historical growth and profitability, the current owner’s reason for selling, the quality of their financial statements, the projected future profitability, the existing client base, any barriers to entry and any regulatory burden. Other factors include competition, the future of the subject industry and the future of the company’s products. Also look at the company’s technology tools and any possible environmental concerns.

Once due diligence and negotiations are complete, and the sale price is determined, the next step for the broker and buyer is to develop a plan to finance the transaction. The following list describes just some of the documentation that brokers will need to adequately prepare the loan request package:

• A detailed description of the subject business
• A signed copy of the sales agreement
• A detailed list of assets that will serve as loan collateral, including estimates of each item’s current value
• A copy of the real estate purchase contract, if real property is involved
• The complete business plan that states the company’s objective and how its goals will be accomplished
• The entity’s balance sheets and income statements for the past three years
• The amount of equity the new owner intends to invest in the business

Amenable terms

During the application process, the lender will evaluate and determine the collateral value of the assets involved in the acquisition, which offer security for the loan. In some cases, the aggregate value of the collateral may be less than the requested loan amount.

This does not mean the deal will be turned down. There are several alternatives to be considered, including having the lender make a loan with less than 100% collateral, or having the borrower offer additional collateral, such as a second lien on their home.

Alternatively, the lender may suggest the seller take a carryback on a portion of the sales price and accept a second-lien position behind the lender. If cash flow is an issue, the seller may be willing to defer some or all their payment until such time that the company can support the additional debt.

Repayment terms are issues that must meet everyone’s needs. Again, depending on the lending institution’s policies and liquidity needs, the terms generally can and should be structured to meet the borrower’s cash flow needs as well as the economic life of the collateral.

Seven to 10 years may be a reasonable timeline for equipment financing, while shorter terms are common if working capital is part of the loan proceeds. If commercial real estate is the primary collateral, 20 to 25 years is common. If all types of collateral are included, as is frequently the case, a blended term may be appropriate.

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Commercial mortgage brokers should remember that change-of-ownership financing may not be easy for the buyer to obtain. Therefore, the broker should emphasize the opportunity to cross-sell many other services. This will help to establish a long-lasting, profitable and mutually beneficial relationship with a new entrepreneur, the engineer of the train that runs the economy. ●

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The questions asked, the degree of investigation and the depth of analysis conducted during the underwriting process may generate millions of dollars in revenue or millions of dollars in potential losses for the lending institution at hand. Commercial real estate is a costly investment, making an appropriate level of investigation crucial for the investor and the lender. Aggressive due diligence requires the buyer to spend time inspecting the subject property to mitigate the financial risks associated with the investment.

Objective opinion

Aside from the seller’s disclosure of relevant issues, the responsibility is on the buyer to find any unidentified material issues that could influence the asset value and the ultimate closing of the transaction. Commercial mortgage companies often collaborate with counterparties, vendors, supply chains and technology systems, which can be vital in the risk-analysis process. Statements generated from entities unrelated to the transaction are frequently referred to as third-party reports. An impartial third party is usually a necessity for a successful transaction.

“Typically, title insurance is mandated by banking regulators and it is a requirement if the loan is sold to investors on the secondary market.”

A third-party report can be any study, investigation or other information compiled for the buyer or seller by a professional advisor who offers an objective opinion about the property. These reports protect all parties from making a poor investment decision. Lenders also rely on third-party reports to disclose all material information about the property.

The subject reports are varied in nature, require time to develop and can be costly. If they’re needed, they should be ordered as soon as possible. Mortgage brokers of all experience levels know that commercial real estate transactions are like snowflakes. Some deals may not require each of the third-party reports discussed here, while others may require additional investigation or unique iterations of these reports. Commercial mortgage lending is never a cookie- cutter process.

Appraisal and title

An appraisal is an opinion of value that derives the required equity contribution, loan-to-value ratio and approval of the loan. Banks that are supervised by the Federal Deposit Insurance Corp. (FDIC) are required to have procedures for selecting appraisers, as well as techniques for monitoring appraiser performance. In 2018, the FDIC created a new threshold and began exempting commercial real estate transactions of less than $500,000 from its appraisal requirement.

The appraisal process is driven by the Uniform Standards of Professional Appraisal Practice (USPAP). The purpose of USPAP is to provide guidance for developing and reporting appraisals, and its key provision is to assure independence and competency.

The most commonly used appraisal method in commercial real estate is the income approach, which bases the asset’s value on the income it generates. If the appraiser does not see the value the investor expects, the deal may fall apart. Generally, the investor will have their own perception of value, but they must be ready to support their opinion in quantitative fashion. A commercial mortgage broker should be proactive and provide the lender with as much information as possible to support the value.

Title insurance, meanwhile, is adaptable to meet the needs of a specific deal and will protect parties from issues with the chain of title to the subject property. There are two types of policies offered by title insurance companies. One is the lender’s policy, which protects the lender if there is a problem with the title. The other is the owner’s policy, which protects the buyer if issues are discovered.

A title company will conduct a deep dive into all recorded assignments, encumbrances or other liens that may have been filed against the property. The search concludes with a preliminary title report for the lender. Typically, title insurance is mandated by banking regulators and it is a requirement if the loan is sold to investors on the secondary market.

A title insurance company also may offer various policy endorsements, which protect against more than the standard title problems. There are about 100 different endorsement options that can cover such things as zoning conflicts, boundary errors and environmental concerns.

Surveys and conditions

A land survey is used to identify the existing attributes of a property. These include boundaries, rights of ways, structures, easements, encroachments, water features and other significant characteristics of the property.

A survey will establish the boundary based on the title commitment’s legal description, and it should identify any discrepancies between the existing description and the survey. The survey also will depict how survey-related exceptions to title affect the property. These are items that the title insurance will not cover and are normally found in Schedule B of the preliminary title policy. Circumstances dictate the need for a land survey. For example, if the lot is part of an existing subdivision, the survey requirements will have been previously met.

But if the transaction involves the purchase of raw land or the consolidation of two parcels, a survey will be required by regulators and secondary market investors.

A property conditions report is designed to identify issues with the asset’s physical condition. It may include an inspection of major building components such as heating and cooling systems, fire suppression systems, elevators, roofs, asphalt or sewer lines. The report will provide an estimated useful life for these items.

The use of this report is a frequent best practice for a lender, and it is often based on the size and complexity of the deal. It gives the buyer and lender a second opinion on the condition of the property, and it can confirm inspections completed earlier in the purchase process. The report is designed to be unbiased, giving the investor more credibility and negotiating power while helping to mitigate any lender concerns.

Lenders and regulators will have well-defined policies and procedures for environmental due-diligence tasks. If any level of potential contamination is suspected, an Environmental Site Assessment (ESA) report will look into soil composition, hazardous materials and other suspicious-looking features on the property.

Typically, this process includes a lender checklist, a public domain records search, and a Phase I or Phase II ESA report. If contamination is found, a costly and time-consuming cleanup process must take place, which may well kill the lender’s interest in the deal. Another aspect of environmental due diligence is a complete visual evaluation of all accessible areas of the property for the presence of asbestos and lead-based paint.

In addition, a seismic report may be required in certain states. This assessment will examine all structures to make sure they comply with procedures outlined by the American Society of Civil Engineers.

Market studies and more

A market study will take an in-depth look at the various economic aspects of an investment property. Specifically, it will look at supply and demand in the local market, and it will determine whether the property’s net operating income is likely to grow or shrink over time.

This study is optional and will depend upon the nature of the project. If the venture is unique (e.g., a hotel, golf course or another one-off project), the investor may need a formal market study to confirm their ideas and move the concept forward with other stakeholders. Market reports are generally expensive but usually worth every penny. They can be used to support investment assumptions such as absorption rates, rents and net operating incomes.

Zoning is a structure of legal codes used to develop various parts of a city or county, and it includes different requirements and constraints. The purpose of zoning is to protect existing neighborhoods. A zoning compliance report is a description of the zoning conditions and is often a necessary component of the acquisition process for developers, investors and lenders. In other words, it is an optional but common best practice. In the worst-case scenario, a serious code violation could impede or destroy a transaction. Escrow services are yet another option to consider. Real estate escrow companies act as neutral third parties to hold various deeds, documents and funds involved in the completion of the transaction. An agent deposits funds into an account on behalf of the buyer or seller. An escrow official will obey the directions of the lender, buyer or seller in a prescribed manner when managing the funds and documentation associated with the sale. ●

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We can be assured that changes in interest rates have a significant impact on commercial real estate transactions.

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All shapes and sizes

Time for change

A different company

Moving forward

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Defining success

Changing world

Understanding the client

• How does the lender wish to expand its loan portfolio?
• What is the lender’s current appetite for risk?
• What loan size best fits the lender’s current goals?
• Does the lender have collateral preferences?
• Does the lender have project location requirements?
• What is the lender’s specific underwriting criteria?

Developing relationships

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The only way to do this is to have a basic understanding of how the lender evaluates the riskiness of borrowers and loan proposals. Accordingly, you must understand the concept of leverage. In finance, leverage is any technique involving the use of additional debt rather than equity in the purchase of new assets, with the anticipation that the after-tax profit for an investor will be greatly enhanced.

The greater the ratio of debt to equity in the financing mix, the greater the leverage. Leverage is powerful, but it has the potential to be deadly. A highly leveraged borrower is more susceptible to business or market downturns than those with lower debt-to-equity positions. Be assured that lenders are paying attention to a borrower’s leverage levels when evaluating a new commercial mortgage request in today’s market.

Capital stack

A company’s capital structure is primarily comprised of two types of financing: long-term debt and the owner’s equity. This mix will vary depending on the proposed transaction. There is no best or perfect ratio.

Too much debt, however, hurts earnings by creating a high-interest expense. Lenders may become nervous about the potential for loan default if they suspect that a company is excessively leveraged. This makes it more difficult to secure additional debt and may cause the borrower’s personal credit rating to drop, making the cost of additional debt even higher.

If it’s effectively managed, however, the addition of debt can be a much more attractive option than taking on an equity partner. Debt is expensive but less so than equity capital. With debt capital, the interest rate is known, agreed upon and restricted to a defined period of time. Equity, on the other hand, is considerably more expensive than debt and does not have a maturity date. The equity investor will demand some type of dividend during the life span of their investment in the company.

An investor also will expect a higher rate of return when an investment carries more risk. Generally, the equity investor will demand higher returns for investing in a small, privately held company with limited resources, marginal liquidity, constrained market share, and a single product or service as its primary source of income.

Power of leverage 

Investors use leverage to increase their purchase power in the marketplace. Although leverage is a great concept on paper, it also is a fair-weather friend. The debt magnifies the return on investment when revenues are plentiful, but it also amplifies losses when revenues falter.

Say, for example, that an investor finances the purchase of an $800,000 property with $600,000 in debt and $200,000 in equity. If property gains 10% in value, or $80,000, in the first year following the purchase, the return on investment is 40% ($80,000 divided by $200,000). Conversely, if the same property declines in value by 10%, the investor will have a corresponding loss of 40%. The point is that the debt has facilitated these massive profits and losses.

At the same time, it is often unclear to an investor — or a lender, for that matter — what the ideal leverage ratio should be. Lenders require a lot of information when considering the appropriate leverage. Say that a company has equity of $4 million and is carrying a total debt of $25 million. The debt-to-equity ratio is 6.25.

Is this good, bad or just right? The fact is, without a lot more information, you can’t make an intelligent decision. These numbers don’t tell us what the company’s historical debt-to-equity ratio has been, nor do we know the leverage levels of similar companies within the same industry. One ratio by itself is meaningless because it provides little insight about a company’s performance and doesn’t tell enough of the story to make a good decision.

Complex analysis

When interpreting the debt-to-equity ratio, the industry itself is a critical factor in the evaluation, and different industries have various capital requirements. A relatively high debt-to-equity ratio may be the norm in one industry, while a low ratio may be common for another.

The appropriate leverage depends on the project’s potential profitability; the nature and magnitude of its risks; the strength of the collateral; and the creditworthiness and experience of the borrowers. There are numerous shortcomings tied to the use of excessive leverage. Asset values may rapidly decline and financial risk may increase due to higher leverage. Poorly managed companies also are less likely to support high leverage.

A high debt-to-equity ratio frequently indicates that a company is optimistic and is willing to finance its expansion with greater levels of debt. This decision, however, may ultimately destabilize the company. The company is taking on extra expenses. If the debt is excessive and revenues are unstable, the company will be challenged to service the debt. This increases the risk of default and, in extreme cases, can lead to insolvency.

As previously discussed, there is no single perfect leverage level. As the variables and assumptions change, the appropriate ratio also will change. A well-constructed financial model allows management to make certain assumptions about optimal leverage ratios, but it is important to remember that these are only assumptions. The final results have yet to unfold and therein lies the risk of leverage.

In today’s commercial real estate market, there is a lot of capital ready to deploy and many lenders are willing to be aggressive. Just because your borrower has the opportunity to fund a transaction at a 90% debt level, however, does not mean that this the best financial decision. Leverage always comes with greater operational risk. ●

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Banks use a number of accounting metrics to gauge a borrower’s credit-worthiness and these are worth learning. Unfortunately, it also is true that some banks automatically disqualify certain business types for no rational reasons. Commercial mortgage brokers should take time to understand how underwriting standards develop and evolve, as well as some of the finer points of the process.

Fundamental lending practices are constantly changing. They are frequently rewritten by banks to reflect evolving economic conditions, aggressive competition, bank management philosophy, market objectives and, to some extent, recent experiences with specific industries. After every economic event there is confusion and uncertainty within the market. Over time, a bank’s new lending strategy permeates the entire organization and new credit standards appear.

Commercial mortgage brokers should stay abreast of the changes in each of their lending relationships. You need to stay up to date to give yourself the best chance of success. Lenders want to receive a complete loan application with a financial analysis that demonstrates the inherent risks. The analysis should justify why the bank should approve the request.

Influence of leadership

To some mortgage brokers, a bank’s lending criteria may appear overly conservative and designed to decline most loan requests, with no basis in reality or standards that are inconsistent from bank to bank. Of course, there are institutional differences between lending cultures and policies, but all successful banks have three basic priorities: safety and soundness, profitability and growth.

Generally speaking, a bank’s policies will reflect standard underwriting concepts used by the vast majority of its competitors. It is important to note, however, that a bank’s philosophy also reflects the attitudes of its management — and these attitudes are influenced by these individuals’ varying experiences. On occasion, individual preferences can lead to bad policies within a bank that eventually become fixed within the institution’s culture. Sometimes these attitudes are exported to competing lenders.

Say, for example, that a bank’s senior lending officer has had a negative experience with a transportation company, a real estate developer, a car wash or an electronic assembly plant. There’s a strong probability that the bank will make it more difficult or more expensive for these out-of-favor business types to obtain a loan.

This can translate into a higher downpayment requirement, shorter repayment terms, higher interest rates or even an unwritten rule not to do business with a particular business sector. Bank policies are based on a greater perceived risk associated with the subject industry, simply because an influential member of the bank may have had a bad experience with a particular business type. This lending practice is simply wrong and should not be permitted in a judiciously managed environment.

Accurate gauge

Despite this problem, bank underwriting tends to be logical and underpinned by sound accounting practices. Essentially, the bank attempts to underwrite each loan application on the basis of the recognized risk. 

Risk can be divided into a dozen or more categories. The major issues include the risk of management failure, the risk of loan default, an adverse change for the industry in question, and downturns in the regional or national economies. These risks are absolutely real. If the bank is to remain in business and earn a reasonable profit, it needs to accurately gauge the risk. There is little room for error. 

The lender can mitigate perceived risks by understanding the loan request in great detail. Part of this is understanding the state of the industry, the granular details about the collateral and current economic conditions. Banks also want a clear picture of the company’s bottom line, as well as the risk associated with the borrower and their capacity to assume additional debt. A commercial mortgage broker should pay attention to these details, too. You will move your request along more quickly and efficiently if the creditworthiness of the business is adequately addressed in the application.

Banks evaluate this bottom line in a number of ways, some of which is part art and part science. One essential area involves the company’s liquidity, or its ability to turn assets into cash. Liquid assets are needed to deal with unexpected short-term predicaments. They have greater importance for the company’s survival in both the short and long term while profitability has secondary importance.

Liquidity measures

Liquidity can be measured in several ways. The first is working capital, which is the company’s current assets minus its liabilities. Working capital is important because it is necessary for businesses to remain solvent and open the doors the next day.

Another important liquidity metric is the current ratio, which is calculated by dividing the company’s current assets by its current liabilities. A ratio of 1 means that if the company’s current assets are liquidated, there will be sufficient funds to pay off liabilities. A ratio of less than 1 means the company would need to find additional funds to pay off its liabilities. Banks usually consider a ratio of 1 satisfactory.

Another key metric is the quick ratio. Also known as the acid-test ratio, it measures a company’s ability to pay off short-term liabilities with assets quickly converted to cash. It is especially useful in measuring convertible assets of a business when it is difficult to sell inventories.

Other liquidity metrics measure a company’s efficiency in collecting accounts receivable and how quickly it turns over its stored inventory. This so-called “asset conversion cycle” measures how long it takes a company to convert inventory and accounts receivables into cash from sales. The cycle charts the process by which cash is used to create goods and services, deliver them to customers, then collect the resulting receivables and convert them back into cash. The nature of this cycle determines the extent to which a business has either a net inflow or outflow of cash.

All of these ratios can reveal additional insight about a company’s growth, profitability and overall performance — all of which is needed to properly underwrite a loan request. These are only some of the major metrics. There are dozens of financial ratios and a meaningful interpretation of them is essential to appraise the financial health of the subject organization, which is the objective of financial-statement analysis. This is a time-tested method of analyzing a business, and it is used by investment firms, commercial banks and business owners to gauge a company’s current financial condition as well as its potential growth and profitability.

● ● ●

Although financial ratios offer valuable insight into a company, commercial mortgage brokers and lenders should pair them with other metrics to obtain a wider view of a company’s fiscal health. Calculating a ratio or series of ratios is only part of the process of financial-statement analysis. An equally meaningful process is to decipher the meaning of the ratios. The second part of the underwriting process — interpreting the data — is more art than science. ●

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