Property Cash Flow is Key
For those who have bought, sold, or financed commercial real estate, you understand that your property cash flow, after all property expenses, is what will determine the income value of the property. This property cash flow,or Net Operating Income (NOI), allows your lender to quickly determine review the loan amount requested. They will determine whether the loan falls within the Loan-to-Value tolerance as determined by their lending policies. It also is the basis upon which the lender and Appraisers estimate the market value of the property.
Presenting your NOI, provides the lender the assurance that the property has both current, and anticipated cash flow (after accounting for all existing and anticipated property expenses) to adequately repay the requested loan (“service the debt”).
Your Lender’s Perspective. Rent Stabilization.
Lenders will typically take a conservative but realistic approach to the recognition of income. This will take into account historical property performance.Current market realities, and the performance of similar properties in the vicinity of yours will also be reviewed. This exercise is known as rent stabilization.
Rent stabilization by the lender can take a number of forms. This may simply be an annualization of current rents. It may involve applying market level rents if your lender thinks certain of your tenants are paying rents in excess of current market rent levels. Your lender may conclude that a specific tenant may lacks credit worthiness sufficient to allow the lender to fully recognize their present rent. If rents are $20 per sq. ft., and your local independent retailer is paying $30 per sq. ft., (significantly higher rents than market) the Lender may view this as a potentially risky situation.
Alternatively, a tenant’s rent term may expire in advance of the anticipated mortgage term expiry. The lender may wish to avoid a situation where future property cash flow is lower than present levels.
Lender rent stabilization may also result from a lender recognizing what they consider to be base rental rate. This would be the rent excluding any excess tenant payments resulting from tenant repayment of fit-up allowances, or other special provisions.
In most cases it is not possible, in advance, to know what underwriting approach your lender will employ. Your role is to simply present clear and concise historical, current, and projected income and expense figures, with any discrepancies and anomalies duly noted and explained.
A Word about Vacancy Allowance
Your property may presently be fully leased. For loan underwriting and property valuation purposes, Lenders (and real estate appraisers) typically account for the fact that there is a normal level of anticipated vacancy within your local market, for properties similar to yours.
Even experienced real estate investors expect the possibility of periodic vacancy and rent collection loss. When recognized by your lender in their review, it is typically referred to as a vacancy and bad debt “allowance”. It forms an integral part of their loan underwriting process, to arrive at a stabilized rent figure.
How is it determined?
How does your lender determine the appropriate vacancy “allowance”? Typically through reference to market data published by major commercial real estate brokerage firms. Local and regional housing authorities often survey landlords for market data. CMHC does as well, and consequently vacancy rates are also typically readily available for multi-family residential properties. Local knowledgeable commercial real estate brokers, and appraisers, are often also a good source of this information.
The application of a vacancy and bad debt factor by your lender is an important recognition of market realities. However, you may have a commercial tenants whose lease covenant (or “promise to pay”) is considered undoubted, (in other words, the tenant’s likelihood of not paying rent is highly unlikely). Their Lease terms extend beyond the term of the financing being requested. The application of a vacancy allowance by your lender, on that tenant’s income is likely unnecessary. The loss of income from that particular tenant is remote. Know this and discuss with your lender the appropriateness of excluding a vacancy allowance.
Lenders will not necessarily use the term “Stabilized” rent. They may in fact prefer “Underwritten” rent, however you now know the importance of the analysis that your lender performs. You can present your income and expenses with confidence. You will understand that NOI forms the basis of the lenders loan analysis.