The Rochester commercial real estate market has remained
resilient in the post COVID, higher interest rate environment. While
new construction and redevelopment projects have slowed since
the pandemic, commercial property purchase/sell transactions
remain consistent. As expected, refinance requests have declined
meaningfully with the rapid rise in interest rates.
Commercial real estate (CRE) is income producing property
used solely for business purposes. There are three basic types
of commercial real estate projects. These include acquisition,
construction, or redevelopment of a property.
- Acquisition - When a buyer purchases a
property from another individual or entity.
- New construction - Construction of a
building from the ground up on a previous
vacant parcel of land.
- Redevelopment of a property - When a
building is either owned or acquired
and is renovated to simply improve it’s
current use (provide more amenities
and charge higher rents) or change the
use of the property. An example of this
is occurring in larger cities where former
industrial buildings are being converted
into apartments.
Regardless of which type of commercial real estate project you
are considering, there are several key metrics a bank is going
to evaluate. They include cash flow, collateral, and the owner/
sponsor.
Cash Flow: If the project is a simple acquisition, then the bank
will review the historical annual cash flow of the property. Cash
flow is total annual rents collected less annual expenses. For
new construction or a redevelopment project the bank will also
consider what the project cash flow is expected to be. Questions
to consider include:
- Are the projected rents below, within, or above current
market rents for similar properties?
- Are projected expenses below, within, or above expenses
for similar properties?
- How long will it take to lease up the property?
Banks want to see that the property will generate enough cash
flow to cover the mortgage payments. They will calculate a Debt
Service Coverage Ratio (DSCR). The DSCR formula is (net income +
depreciation/amortization + interest expense) divided by (annual
principal and interest debt payments). Typically banks would like
to see a DSCR of at least 1.2:1.0.
Collateral: This is the actual property that will secure the loan.
The bank will file a mortgage on the property to collateralize the
loan and the maximum loan to value that a bank will lend to is
80%. This means that if the property is worth $100 the maximum
a bank will lend is $80. Banks will hire an independent appraiser
to complete an appraisal to determine the property value. For a
construction or redevelopment loan, in addition to valuing the
property on an ‘As-Is’ basis, the appraiser will also provide an
expected value once the project is completed (this is called the
‘As-Complete’ value).
Owner/Sponsor: Banks expect the owners
(also known as the sponsors) to personally
guaranty this type of loan. A personal guaranty
is essentially the owner signing a document
that states if the property is unable to repay
the loan, they (the owner) will repay the loan.
Because of this, the bank will analyze the
owner’s financial information and evaluate
other sources of income including wages from
their job, income from any businesses they
own, investment income such as dividends
or interest, and income from other real estate
projects. Additionally, the bank look for other
sources of liquidity including savings accounts,
mutual funds, bonds, and other marketable securities. These
other sources of income and liquidity are important in case the
project the bank is financing ever faces an unexpected challenge
such as a mechanical system failure (furnace/boiler, roof, or other
system needs to be replaced, etc.) or unexpected vacancies.
Having those other funds can pay for that replacement/repair
or help support the mortgage payments during an unexpected
vacancy.
As a community, we are fortunate that the commercial real estate
market in our area continues to remain healthy with properties
holding their values. When considering a commercial real
estate investment, it is extremely important to consult with your
commercial banker early in the process so they can provide advice
and feedback throughout the process.
To learn more about a Commercial Real Estate loan, contact your
lender today at (585) 419-0670.
This material provided by Tim Johnson