Qualification Phase of the Commercial Lending Process
Steelhead Capital offers a private banking style approach to helping you save time and money on your commercial loans.
-- Transcript of Capital Synergies Podcast
DARBY: Hello, this is Darby Worley for the new Capital Synergies talk show. Mr. A. Sean Aguilar, CCIM, and vice president of Steelhead Capital is here with us again today to talk about the second phase of the commercial lending process called Qualification. Sean, Welcome back.
SEAN: Thank you, Darby, it's good to be back.
DARBY: You covered this a little in our first call, but approximately how much down should an investor be capable of paying on a commercial loan?
SEAN: Typically they should at least consider putting at least 20% down. Sometimes it may be even more. Like 25% down. It really is going to be probably dictated by the asset type. You know, whether...
DARBY: I see. Does it vary from one commercial property type to another?
SEAN: Exactly, correct. Vendors tend to be willing to leverage more on multi-family apartment building loans as opposed towards industrial or retail.
DARBY: Okay.
SEAN: So, that's one of the areas where there's a differentiation traditionally.
DARBY: Okay. At what stage will people be expected to put down processing fees for a loan application, and what kind of funds are they looking at gathering up for those fees?
SEAN: Usually what happens is after the borrower puts the property under contract, or if they're re-financing, what they'll do is they'll have to make a loan application. At that point in time the lender will collect an up-front application fee, and a percentage of that money usually is nonrefundable, and that's what used to pay for the appraisal report and some third party reports. They may or may not at that time ask for processing fees. But there is an initial application fee at the time when they make the actual loan application.
DARBY: And how big of a chunk is that? How big of a percentage?
SEAN: Typically it ranges. Banks tend to have the lower of the application fees, and that tends to be - say for an apartment building it could be anywhere from maybe $3,500 up to $12,000. With the conduit lenders and the pension fund along those lines, that tends to be anywhere from $7,500 up to $15,000 or more. So clearly the banks are the least expensive when it comes to making that initial deposit for those application fees.
DARBY: In terms of net worth, what does that have to do with the application process, and how do the lenders determine - you know, what goes into determining an individual's net worth?
SEAN: As part of the paper work, one of the things the applicant is going to want to provide to the lender is a financial statement and balance sheet. In that financial statement the lender will be looking at their overall net worth and compare that to how much they're borrowing. With that net worth they also are looking at liquidity, if you will, from that net worth. But it really varies with every lender on what the net worth of an applicant should be when it looks at how much loan dollars you are applying for. Some lenders it's more of a function of verifying how many mortgage payments they have in liquidity on their balance sheet as opposed to just what their overall net worth is, because they want to figure out how they can shore up any short falls, if you will. For other lenders, if they look at their overall net worth, and their formula as well, we like to see maybe five- or 10% of liquidity, liquid assets of that net worth for the loan they're applying for.
DARBY: But in general it's a more strict process than, say….
SEAN: Well compared to residential lending, it's a lot different, a lot stricter. There's a larger requirement there, and they're more diligent in that area. They are looking at liquidity as a component of your net worth.
DARBY: Let’s move into talking about some of the various types of loans that people could expect to be offered. What’s the difference between a “full doc” and a more traditional loan?
SEAN: Right now, we’re seeing a lot of packaging of just being full documentation, which means on a commercial platform the bar should be expected prepared for by two years’ worth of federal tax returns with all the supporting statements, a balance sheet, you know, a financial statement listing your assets and liabilities. They tend to want to see some bank statements on your liquid assets and that’s kind of what they’re looking at on the full doc side. Plus then they want to see the operating statements of the financial statements on the subject property. Unlike residential, commercial ones in general tend to be more geared towards full documentation, where I think if you’re just doing residential loans they’ve had limited documentation, stated documentation. Documentation requirements have been basically pretty liberal on the [ph 5:39 buy ] so anybody that’s making the cross over from residential to the commercial or multi-type family platform should be prepared to provide the documentation we just referenced earlier.
DARBY: When you’re talking about a financial statement, is that something that John Q. Public can dummy up for himself, or is that something that you have to hire somebody to do for you?
SEAN: Here at Steelhead Capital, we have forms that we allow our clients to use, that we quite frankly prefer them to use, for filling out their financial statements, which you know, on their income statements or financial statements or balance sheets, if you will, so that we have some unison for the documentation that they’re going to submit. We actually work with them and help them assemble it if they don’t. It’s a good habit that what we do with our clients annually is we just kind date their financial statements with them. Because it’s really important to be prepared and have your paper work available and in place up front so that you don’t lose time.
When you’re under a purchase contract, your clock is ticking. You have certain deadlines there that you need to perform and meet, whether it’s a contingency or inspection deadlines, and things along those lines. If you have a financing deadline, you really need to get all this paper work prepared up front, have it in place, so that once you do get that property under a contract you can go right to the loan process and submit your paper work, and start getting feedback from the lenders on what type of terms and stuff they can offer you.
DARBY: In the residential phase, there are these loans that are called Interest Only loans. Does anything like that exist in the commercial market?
SEAN: They do. We have seen a lot of it over the last 18 months. Not so much with the banks but more so with pension funds and the conduit loans. That platform will offer a 30-year amortization. A ten-year term. And may be offering from one- to three- to five years of interest only. Experiencing now what’s happening in the capital markets and the changes of what’s going on out there, and also with the problems we’re having in the residential [ph 8:02 sub-prime] market, it’s fair to say that we’re probably going to start seeing interest only loans go away. Interest Only loans are really beneficial. When you are qualifying for a piece of property you’re looking at a debt service coverage ratio, and obviously you can quality for more loan proceeds if you’re calculating a payment on interest only basis versus a fully amortized basis. We’re probably going to see that maybe start to burn off, but what we’ve been noticing right now is we’re seeing some lenders maybe extending their amortization out to 40 years from 30 years. What that effectively will do will lower the payment and give you maybe more loan proceeds. But then again…
DARBY: Is that a good situation to get them into though?
SEAN: I think if it was a residential loan and it was actually a fully amortized loan over 30 years or 40 years, I would say yes, from the sense that you’re going to be paying your loan down a lot slower. But with commercial properties, a majority of commercial loans tend to have balloons. They’ll stretch the payment over 30 years, but there’ll be a balloon, or call date, in 10 years. So you’re always going to have that re-financing scenario down the road if you choose to hold it for that long. I don’t think it really can be problematic. I think where it would become problematic is when you’re doing your analysis and you’re using an interest only loan, well then you’re not building up any equity through debt reduction. So you are therefore just relying totally on appreciation to create equity.
If you don’t size up your investment properly, you could be doing yourself a disservice by maybe over-estimating or aggressively estimating that you’re going to have a strong appreciation on the property you have, just from the market. As we all know that isn’t always what takes place. So it’s nice to have loans where you are making your payments through amortizing the debt and reducing the mortgage balance. At least you know you’re building equity from that side of the table, therefore not strictly relying on market appreciation for creating the value for you.
DARBY: Let’s move forward and talk a little bit about the asset strategy of the property. What is your advice, your counsel, about how to match the asset strategy of the property to the loan terms?
SEAN: That’s a really important and critical component of buying any property. When you’re looking at that investment, you’ve got to think about your exit strategy. Is it a long term hold for me? Short term hold? It’s really important to match the appropriate debt with that play, with that investment. Long term hold, you’ll tend to go to a fixed rate portion. If it’s a short term hold, you’ll use a short term loan product to match that.
DARBY: I guess the whole idea is to get in and get out of commercial real estate, right? It’s not like you’re buying a house you’re going to live in forever. The goal is typically to make some money on it and move on.
SEAN: Sure, you want to make money and some people, what they’ll do is make money by repositioning a piece of property. With that they’ll get a bridge loan which is a short term loan. So if you have a piece of property that maybe has a lot of vacancy in it, maybe the play is then to acquire that – use short term financing, to take it down and then as you start renovating and leasing up that space, then you have the opportunity of doing one of two things.
You can take it and sell it and hopeful do a 10-31 exchange into another property. Or you may want to keep it because you’ve increased the income so much, and then put long term debt on it, so that you then could have fixed cost, if you will. Therefore you will be able to determine what your cash flow is going to be on a more consistent basis.
DARBY: So there are long term fixed rates available to support those long term holds?
SEAN: Yes, correct. And those long term fixed rates, unlike residential, which is usually 30 years - again on the multi-family commercial platform they tend to be traditionally up to about 10 years’ term.
DARBY: Let’s talk a little bit about pre-payment. Is that a concern for your clients? Do you have to pick a loan based on whether or not you’re going to be able to do that?
SEAN: It kind of dove tails back to your question about exit strategies, and the property, and picking the right debt. Every loan has some form of pre-payment penalty on the commercial platform, whether it is a flexible, what you call a “flexible pre-pay” which is a 5-4-3-2-1 and it ….
DARBY: Explain that a little.
SEAN: What that essentially means, some lenders will do a five-year or maybe they’ll do a seven-year fixed rate loan. But if you want to pay off on the first year, they’re going to charge you a 5% pre-payment penalty, so it would be 5% of the outstanding balance at that time. You pay off the second year, maybe it’s 4%. If you pay off the third year, it’s 3%. So it descends as the long term burns off. That’s one side of a pre-payment penalty. It’s what we call “flexible descending pre-pay.”
But then there’s ones that are more onerous, which are either a form of defeasance or yield maintenance. Those ones are much more expensive traditionally, and a little bit more difficult to work with. So when you’re looking at properties to buy, and it it’s a repositioned property, you probably want a bridge loan as opposed to long term finance loan. The bridge loan will have some form of flexible fee pay, and that’s what’s beneficial for that.
If you buy something that’s a stabilized asset or you want to keep it for a long term, then you’re probably going to want to get a long term fixed rate loan. But those tend to have more of what we call either a Yield Maintenance or a Defeasing component to that loan. That form of the pre-payment is a lot more onerous and a lot more expensive.
DARBY: Before we wrap, are there any closing thoughts or words of wisdom for our listeners as they go into the qualification process?
SEAN: I think being prepared is just so much easier to help you with your execution. Having your tax returns available, having your financial statements updated, having your own paperwork in order – is really a great start as you go into the phase of making application with a lender.
When you’re looking at the property and what kind of information to get, usually you get two years of operating statements and the rent roll and the year-to-date profit and loss on that property. But we really would encourage you to try to get 12 months of historical operating statements, and the term and the jargon in the industry is the “trailing 12 months.”
It’s good to get a breakdown like that because it allows you to look for trends in your expenses, and otherwise you could fall into a trap of, you know, if you’re buying a piece of property you take the first six months of income expenses and you analyze it. You have to really get back into the napkin method to really get an idea how the property is performing. But if the properties are in areas where there is heavy weather winters, those tend to have higher utility bills in the first quarter of the year. Those utility bills tend to drop definitely the third quarter of the year, for sure when summer hits.
So you like to see those 12 months of trailing expenses, because if you see these spikes in certain item costs, you’re at least able to focus on them and ask some questions, “Hey, why is all of a sudden for two months the gas bill is extremely high?” Sometimes there’s a really logical reason for it because maybe that was a really heavy winter. Or maybe it was just a one time thing as opposed to a consistent thing. It’ll help you get your arms a lot better around those expenses and you can deal with it with more certainty.
Otherwise, if you kind of just do the back-of-the-napkin thing and your lender goes along with that, you may be doing yourself a disservice at the end of the day, where the property maybe would have been eligible for more loan proceeds, and you actually got less because you really didn’t kind of look at the monthly breakout. On the paperwork side and getting those 12 months break down, it’s really beneficial because it allows you to see where the actual peaks and valleys are in the performance of the property. That’s what you kind of want to do. You want to find out, Hey, how’s that going to hit my cash flow?
DARBY: Yes, you need to know that anyway or how are you going to manage your property?
SEAN: Exactly. Whether you hire a third party management company or you are, you want to know, Hey, how is this going to impact my monthly cash flow? If you go out and gather some investors to do this with, their expectation is they’re going to want some distribution, some returns. Whether it’s done monthly or quarterly, that’s a negotiated item. But if you’re having these peaks and valleys that are a part of the property – and you’re always going to have those because of seasonalities, if you will – that’s fine. But you just want to be able to plan for that properly so that you can make sure there’s a reasonable expectation of how the distributions are going to be done, and why they’ll be the amounts, why they’re maybe not consistent. Getting those trailing 12 months and really reviewing it and understanding it is just a critical thing to have. It will just help with the overall success of the investment.
DARBY: Someone said that you have a kind of list of things that you should have put together on your web site?
SEAN: I believe we do, but they can definitely always call us or e-mail us, because depending on the type of property and the asset class, it’s going to dictate what specifically we would need for those properties to help underwrite it. A quick example: of course from everybody will need their tax returns, financial statements, things along those lines. But when it comes to the property, if it’s an apartment building you’re looking at the rent rolls, if you will, to show the occupants, seeing what the rents are that are being collected.
But if you’re looking at a retail strip center, you’re probably going to want to see the lease summaries in addition to the rent roll. You’ll want to be able to see when those leases expire and roll over, and if they have options, you know, what that new rent would be. Each property has specific paperwork that we would need to see. So, again, calling us or calling your lender and discussing the deal specifically is the best way to get the list that you need for that.
DARBY: Tell us your web site again?
SEAN: We are at www.steelheadcapital.com.
DARBY: Great. Well, thanks so much, Sean, for joining us again. So guys, once your initial documents are together, it’s time then to move on to the third phase of the commercial lending process, which is called Underwriting. We’re going to cover that on our next show. Until this has been Darby Worley for Capital Synergies. Thanks for listening.
