Cash, Cash, Cash: What Lenders Want to See in Commercial Property

Sure the traditional three important factors (location location and location) have value when a lender evaluates your loan application. But what that banker is really looking for to approve your loan is that your property can generate cold hard cash flow.

According to the Wall Street Journal in February “The Federal Reserve’s latest survey of senior loan officers showed 80% of domestic banks tightened lending standards on commercial real-estate loans in the past three months — the highest level since the question was first asked in 1990.”[1]

Given the tighter lending market how can an owner demonstrate that your property can deliver the cash flow to service the debt that you’re requesting?

A third party independent appraisal is key to this demonstration. All states require appraisers to be certified or licensed to provide appraisals for federally regulated lenders. The Appraisal Foundation[2] a non-profit organization authorized by Congress as the source of appraisal standards and qualifications sets standards which the states must adopt or surpass for all types of appraisals including Real Property Appraiser Qualification Criteria.

The criteria include qualifications for four levels of Real Property Appraisers ranging from Appraiser Trainee to Certified General Real Property Appraiser. For commercial property you’ll need an appraisal from a Certified General Real Property Appraiser.   For a higher level of education (and credibility) you’ll want to select one who is a Member of the Appraisal Institute[3] (MAI).

The Appraisal Institute defines an appraisal as “a professional appraiser’s opinion of value. The preparation of an appraisal involves research into appropriate market areas; the assembly and analysis of information pertinent to a property; and the knowledge experience and professional judgment of the appraiser.” It’s more than just a review of comparable properties. â€œThe role of the appraiser is to provide objective impartial and unbiased opinions about the value of real property—providing assistance to those who own manage sell invest in and/or lend money on the security of real estate.” Lenders rely on professional appraisers to assess the potential upside – and risk – of every real estate loan.

The appraiser will assess the property’s current cash flow and review the debt that it carries. He’ll also take a number of factors into account including many that you cannot control.

Market Conditions
Current market conditions play a big role of course including a review of recent local market sales. General economic conditions at a particular time and in a particular market have an effect on the appraisal and on a lender’s decision. A report from the Urban Land Institute and Pricewaterhousecoopers issued in October 2007 identified top markets for 2008. New York is the hottest market the report indicates but other markets that mimic New York’s 24-hour global action will compete as well.

“The most successful investment opportunities are markets on the coast reinforcing the real estate truism that it’s all about location location location. But as many interior cities such as Denver have demonstrated it is possible to transform a city into a 24-hour global pathway city with master planning around infrastructure transportation and economic development.”[4]  The report also indicates that local and regional lenders have been supplanted in many cases by national financial institutions.

If you’re considering a new purchase that’s useful information. Selecting a property in a hot market may help you find a warmer welcome from a lender. But if you’re seeking to borrow against an existing property there are other conditions you can influence which will affect the building’s ability to generate cash flow the appraiser’s opinion of its value and therefore lender’s willingness to make a loan under desirable conditions.

Class of building
Is your property a Class A building? Could it be? Class A properties are defined by the Building Owners and Managers Association as the “most prestigious buildings.” They offer the highest quality design construction and finish. Accessibility and “market presence” are part of the reason that they command the highest rental rates. Covered parking is one amenity that differentiates Class A from Class B.    In your appraisal a Class A building is likely to demonstrate higher cash flow. Some buildings at the high end of Class B (average rents good but not the highest quality finishes and amenities) might be more appealing to tenants (and therefore lenders) with a few upgrades.

Safety and disaster preparedness
A tenant’s choice of commercial space is also influenced by the features that will affect them under unpleasant conditions and this affects cash flow potential. Effective lighting in public spaces is a basic; backup power for outages is essential. In markets with severe weather patterns like earthquakes tornados or hurricanes protection from the effects of these phenomena and systems that facilitate quick recovery should affect the desirability of the property to tenants the value to appraisers and the cash flow potential that lenders are seeking.

Tenants
What’s your occupancy rate? If you have vacancies how long has the space been vacant? Why is it vacant?   The location of the building or the specific space within the building might cause some space to be vacant while other spots are in demand. How long have your tenants been in place? High turnover may be an indicator of an underlying problem either with the building or the building management. Clearly your ability to retain tenants will influence an appraisers view of your property’s value.

Leases and expenses
What are the terms of your leases? Most office space is leased for 5 to 10 year terms with options to renew. An appraiser will look at escalation clauses and how long your tenants are locked in. They’ll compare your rents to market rates. They’ll look at what’s included in Common Area Maintenance (CAM) and whether there are caps.

Expenses fall in two categories: controllable and uncontrollable. In some markets Florida being a prime example the uncontrollable expenses include insurance and real estate taxes. According to a University of Florida survey published in 2006 the higher insurance costs precipitated by the active 2004-2005 hurricane season will have a delayed effect on the commercial market and may be starting to affect rents now in 2008. An appraiser (and a lender) will want to see whether these costs to tenants are capped in the leases. A lease with caps means the owner may have locked in revenue but there’s no lock on his expenses.

“Commercial tenants have not been affected yet on a large scale” according to Wayne Archer director of UF’s Center for Real Estate Studies. â€œCommercial leases are usually for longer periods of at least five years and as these agreements are renewed over the next few years businesses are likely to respond to the cost by increasing rents.”

Owner Operators
If you own a building in which you operate your business a lender will have additional questions. In this situation the lender still needs to determine cash flow. Is your building one that the lender still needs to determine cash flow. Is your building one that because of location or amenities would be snapped up by any tenant? If not the lender needs to know that your business will continue to succeed to enable you to service the debt.

In this case questions would be more about you and your business. How long have you been operating and how well has your business performed? They’ll do background checks on you and the other principals. They’ll assess whether the business you’re operating is in a sector that is likely to benefit from current economic conditions”