Commercial Mortgage and Finance

This lesson is an account of the way in which a prospective motgagee’s interest may be legally and economically affected by lease provisions where either the leasehold or fee estate to which it is attached is mortgaged. The discussion defines certain ideal lease provisions from the point of view of a mortgage of the fee or a leasehold mortgage. Some remedies to adverse provisions which may be encountered in leases are set out.

It is critical, however, to realize that laws differ materially between states and that no legal decisions should be made without consulting counsel in specific jurisdiction in which any subject property is located.

Lease analysis is an exercise in changing points of view. A prospective mortgagee of the fee estate must constantly think of itself as occupying the owner’s position through possible foreclosure or other acquisition of title. Where a leasehold mortgage is involved, its point of view will, in many cases, oppose that of a fee mortgagee. The covenants and conditions of any lease should be analyzed by the lender, not only from the standpoint of the landlord or tenant/ borrower to perform, but also from the standpoint of the mortgagee as a possible owner.

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When considering whether to finance income-producing properties, lenders are especially concerned with the property’s stability. They use three primary analytical techniques to determine the property’s strength — appraising, underwriting and structuring the loan. To increase your chances of funding income properties, you should be familiar with these three elements of the transaction.

Appraising

There are many kinds of appraisals and appraisal methods. For the purposes of commercial mortgages, lenders are generally concerned with getting a reasonable estimate of value upon which they can base their loan amount. This estimate not only must be acceptable to the lender, but it also must be acceptable to
the many auditors and examiners involved in the transaction.

The information in the appraisal report should be accurate. There should not be unexplained inconsistencies within the paperwork regarding sizes, room counts or any other facets. The appraisal should be logical and based on fact.

The appraisal is always an integral part of an income-property financing submission. Still, mortgage bankers and brokers must exercise good judgment to determine exactly how much importance to give to it. Indeed, some lending institutions are appraisal-oriented, while others place priority or equal emphasis on other factors such as sponsorship and credit. This does not mean that some lenders accept inadequate
appraisals; it merely means that they place less emphasis on the appraisal and more emphasis on other basic fundamentals.

Underwriting

The next analytical technique lenders use with income properties is underwriting. Of all the elements, this is perhaps the most misunderstood and least appreciated in our industry as a whole. It is, however, of paramount importance. We are involved in the business of risk analysis. It is in this area where we find the widest divergence of opinion, appetites and attitudes.

Underwriting involves the melding of specific information on a particular project (physical characteristics, location, appraisal, etc.) with general information on similar projects with which institutions have been associated in the past. This melding of data will help the lender make a decision on whether to make a loan commitment.

Further, the underwriting is the basis for determining the loan’s ultimate terms. One lender, for instance, seems perfectly at home with full-documentation loans on shopping centers. Another is willing to consider shopping centers but only so-called prime centers and only on a conservative basis. Some lenders will accept luxury apartments, while others find these types of investment totally unacceptable.

Brokers must intimately know the underwriting patterns of the various lenders. They will vary among properties and among geographic locations, but there are a few factors that will be assessed in almost every type of income property. These universal considerations include the loan-to-value ratio, the debt-service-coverage ratio, the break-even point, the loan and the income per unit typical of the property type in question. You may also wish to chart, as a routine matter, appropriate area sizes, parking requirements and typical amenities.

Keep alert to the elements of prudent underwriting. It will make it easier to determine what lenders find acceptable with the majority of projects.

Structuring the loan

When it comes to structuring the loan, you have to make a significant judgment concerning the proper amount of financing that a particular property can sustain. The judgment must be based on a thorough analysis of the project’s characteristics.

The recommended financing must be attuned to the particular lender with whom you are dealing. If, for instance, the property is a nursing home, and your one nursing home lender has never made a loan in excess of 70 percent of value or has never made a nursing home loan with less than a 1.5 debt-service-coverage ratio, keep those facts firmly in mind when negotiating an application and recommending a particular
dollar amount to the lender.

For some borrowers, the aim of financing is not necessarily to arrange for a proper level of financing as much as it is to obtain the highest dollar amount at the lowest rate for the longest term. On the other side of the fence, however, some lenders believe they should strive for the lowest number of dollars at the highest interest rate for a term that keeps the loan classified as a long-term, permanent loan. For many of these
lenders, the actual amount of the loan is immaterial. Fortunately, there are many members of our industry who aspire to place a proper level of financing upon any income-producing property.

Lenders’ levels of interest will vary between types of properties and industries. There are some life-insurance lenders that have had phenomenal success with financing industrial properties or shopping centers or motels and are willing to lend more aggressively in those categories.

Many experienced players in our industry will agree that more projects have failed from overfinancing than from underfinancing, and a lot of people have been driven from our industry because they never acquired the self-discipline to allow projects to stand on their own merits. Older and wiser heads in our industry can
recount tale after tale of competent borrowers who began counting on the funds from their next project to bail out a previous one.

Ultimately, the structure of the loan must be reasonable for the property type, borrower and lender. It is this combination of project, sponsor and lender whose interests must all be evaluated and equalized if one is to be associated with successful income-producing properties.

Financing income-producing real estate is not an exact science. It requires subjective analysis, experience, and an ability to be innovative and creative. Some fundamentals, however, are unchanging. Projects generally are analyzed by location, physical property and borrower strength. Generally, the location must be suitable for the project. The location elements that lenders typically consider are:

■ Compatibility with environment
■ Functionality of entrances and exits
■ Transportation options
■ Workforce potential
■ Utilities and zoning in the area
■ Other characteristics of the location and market

Further, projects in good locations have been ruined by poor financing, and projects in marginal
locations have been successful because of strong financing.

When looking at the physical property itself, lenders usually analyze:

■ The size of the facility
■ The parking situation
■ Drive-by appeal
■ On-site amenities
■ Physical and mechanical components of the building
■ Functional and economic utility
■ Physically and economically obsolete aspects

In assessing most of these elements, common sense may be the most important tool. To illustrate this point, consider an apartment with no bathroom or a “full-service” hotel without adequate parking. Lenders must be able to judge the project for its current and future market appeal, and function plays a large role.

Lenders also often require further explanation when it comes to general-purpose, limited-purpose or single-purpose properties. General-purpose properties are those for which there is a competitive rental demand with generally accepted physical characteristics that appeal to many general users. Examples are warehouses and retail stores. A limited-purpose property would be a facility like a service station or department store capable of conversion to another use. A single-purpose property would be a facility such as an oil refinery that is difficult to convert.

When looking at borrower strength, lenders will want to analyze the property’s developer and manager. Although an individual partnership or corporation may develop the real estate, it may not manage the property, collect the rent and pay the debt.

You’ll also want to look at what other properties the developer has produced — particularly, those similar to the subject property. Developing includes finding the land, arranging for physical development, arranging for financing and bringing the concept to fruition. Know the amount of real estate actually managed by the sponsorship group and know its payment record.

Overall, to be successful, it is important to understand these three basic characteristics of a given project.

A loan submission can be likened to a prospectus, although it is typically more complex.

Lenders analyzing a potential loan must examine multiple critical details in the submission. As such, an excellent loan submission gives a complete story of the loan and its relationship to the property in question. It answers all questions relative to the loan scenario and thoroughly details all pros and cons of the security.

In some instances, lenders will require that documents be presented in a particular order, but many items are interrelated and therefore will be examined together. No matter what, there are specific items that brokers should include in all loan submissions.

Application

Although some investors do not require an actual loan-application document, others use it as the basis for the entire loan submission. It carries within it the terms and conditions of the loan scenario. These terms include, but are not limited to the:

■ Loan amount;
■ Loan term;
■ Interest rate;
■ Escrow requirements;
■ Prepayment terms;
■ Types of security documents;
■ Commitment term;
■ Property-insurance coverage; and
■ Fees and closing costs.

Brokers and borrowers should prepare the application with great attention to detail. Because no two borrowers or properties are alike, any special requirements should reflect the borrower’s and the lender’s attitudes properly.

Appraisal

The appraisal helps to establish the security’s fair market value — an essential factor to determining the appropriate loan amount. In general, the following should be included in an appraisal:

■ Property description
■ Neighborhood analysis
■ Property utilities and restrictions
■ The specific approach to value
■ Final value estimate

It cannot be emphasized enough that the mortgage banker is a risk analyst. The value helps determine the potential repayment of the debt within the terms of the mortgage.

Bankers, therefore, must relate value to key points such as debt-repayment coverage, occupancy, expense ratios, vacancy ratios, projected income and other risk considerations. In addition, the appraisal should specifically refer to any unusual elements of the property such as restrictions, easements and conditions of arriving at the value estimates.

The underwriter should be able to make a judgment decision about the future potential disposition of the property based on the information provided in the appraisal.

Financial statements

Any analysis of the borrower without financial statements would be incomplete. If the borrower is an  individual, the statements might not be audited. They must, however, be current (prepared within the past six months) and must reflect all assets and liabilities, including any contingent liabilities.

With a corporate borrower, it is best to request and obtain audited statements. Mortgage brokers and bankers must analyze and be familiar with the income statements and balance sheets in the submission. This way, they can provide the underwriter with the expected input and guidance for analysis.

When dealing with a loan for an existing income-producing property or a property that the owner intends to occupy, include operating statements for at least the past three years. These statements are important in determining a company’s profitability, the rent or long-term debt that the property can sustain, and the company’s growth pattern, both historical and probable. If the company is listed with Standard & Poor’s or Moody’s Investors Service, then a report should be included.

Leases

If a property eventually will be leased, include a copy of the leases in the loan submission. Be sure to prepare and include an analysis of the lease. Because the leases will be reviewed by the legal department, it helps to highlight the major points for a faster review of the submission.

The lease and its terms can be an important factor in deciding whether to make a loan. Be sure to consider the lease’s relationship to the mortgage.

If, for example, the building is constructed for a specific tenant to occupy it, the mortgagee may request that the lease be recorded prior to the mortgage. This ensures that the lease will not be disturbed should a foreclosure occur.

If, however, the investor plans to take possession of the property in the event of foreclosure, the lease must be recorded after the mortgage. This procedure allows the foreclosure action to wipe out the leases, allowing the investor to control occupancy.

Many leases contain information that neither the tenant nor the landlord will want public. In such instances, a short form of the lease may be recorded, thereby providing public notice. This short form reveals no particulars of the lease other than its existence.

For to-be-built projects, letters of intent can indicate the demand for space in the building and can provide insight into the market for such space. Although they are valuable in assessing a building’s future success, they should be taken as only an expressed interest in occupancy — no more, no less.

Letter of transmittal

The letter of transmittal is where you make a recommendation to accept the loan. It also can be used to delineate those items that are included in the submission, if for no other reason than to give a record of what information has been provided.

In a sense, this listing acts as a table of contents for the entire loan submission. This also is the best place to discuss items such as fees, servicing, commitment terms and the probable closing procedure. This letter needn’t be lengthy, but it should be to the point and should include all pertinent facts.

Loan summary

A good loan summary will usually include a reference sheet of important points so the reviewers can grasp the concept of the project and its acceptability as security for a loan. It can include details such as the:

■ Loan amount, term and amortization period;
■ Interest rate;
■ Land value (per square foot);
■ Building value (per square foot);
■ Gross income;
■ Net income;
■ Expenses;
■ Debt service;
■ Cash flow;
■ Debt coverage; and
■ Borrowers’ net worth.

Although many institutional investors have their own procedure or format for reviewing a loan and resenting it to their finance committee, the loan summary nevertheless offers a helpful outline of specific information. It helps the underwriter select which specifics to highlight. This saves time and more important, ensures that the items that are of major importance receive proper analysis.

Plans and specifications

Original plans and specifications give lenders insight into the building’s concept and its physical characteristics. These outlines should give the underwriter a general idea of the building, its total area and the quality of the materials and workmanship that will go into the project.

Outlined plans and specifications normally include information about the:

■ Plot;
■ Floor plan;
■ Elevations;
■ Footings and foundations;
■ Exterior walls, interior walls and ceilings;
■ Roof structure and finish;
■ Floors and floor finish;
■ Mechanical, electrical and plumbing; and
■ On-site improvements.

These outlines are not sophisticated enough to be used for the actual construction of the building,
but they are satisfactory for the purpose of a loan submission. They allow your clients to provide the required information without going to the expense of drafting complete, working drawings.

Be sure to tell your developer clients that should the loan be committed, they will be responsible for providing complete and acceptable plans and specifications before construction on the project can begin. The plans and specs must conform to the previously submitted outlines. The final set of plans and specs is usually prepared in duplicate so the lender may retain one for its files and return the second to the developers as evidence of approval.

Because plans and specifications can be complicated and bulky, it is helpful to provide a written brief accompanying them to the institutional lender. If a more detailed analysis is required, the lender will probably request a review by a qualified engineer or architect.

Final review

Other exhibits that may be pertinent include vacancy surveys, feasibility studies and environmental-
impact studies.

Most real estate lenders require the same information to arrive at a sound investment decision, but they will inevitably have different questions based on their specific investment requirements or attitudes. Some investors will request more detail than others.

The mortgage banker, in the role of correspondent, should research the project sufficiently to avoid future questions. There is no substitute for being completely familiar with the lender’s underwriting procedures. If additional information is requested, however, gather it and make it available quickly to allow for continued and uninterrupted processing.

You should consider the length of the completed submission, as well. It is false to believe that a submission with the most information packaged in an attractive cover is a good loan package. Lenders are primarily concerned with the facts essential to the decision that conforms to investment policy. A dressed-up loan submission is no substitute for a quality investment or a keen understanding of the elements of lending.

A loan submission that is clean and concise is, without a doubt, much easier for lenders to analyze. It also gives them the impression that you understand the elements of safety and risk for their portfolio.

Most loan submissions arrive on the underwriter’s desk without the benefit of your personal appearance. Every exhibit in the package, therefore, must speak for itself. With this in mind, the importance of presenting a loan submission with clear, well-written and succinct thoughts cannot be overemphasized.

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