"I need to be prequalified" is one of the most common statements that come across my desk. People seem to bring over their residential experience of having to get a "prequal" letter from the lender when buying a home. My hope, in this article, is to shed light on a) what lenders care about, b) why it matters and c) how you should spend your time preparing to get a commercial mortgage. So, let's begin our journey…
What Lenders Care About
There are several paths that are necessary to discuss, which are development/construction, investment and owner occupied. When lenders see a construction/development project come across their desk, their antennas go up. Here are the sequential thoughts that go through the banker’s head:
Development/Construction
1. Does he/she own the land already and what is the current zoning?
Having control of the property shows the lender that you are serious. Furthermore, it gives them motivation to give time, and attention, to the project. Notice they are also interested in the zoning, which is the gateway for how a project can, or cannot, be approved. Make sure you have clear details as what kind of zoning, and what is likely to get approved through the local municipality. This can be a big stopping point, if you are not properly prepared.
2. How much cash does he/she have into the project to date?
Cash is king to the lender and they will want tangible evidence. When we say cash, we mean "hard" cash; not what we think it is worth. A lot of this will depend on how long you have owned the property. A general rule of thumb is if you have owned the property for 4 to 5 years or more, then property equity will be acceptable. Anything less than this, you will need to show how much actual money has been injected. Keep a good detailed record (on a spreadsheet) of how much you have spent from inception. Furthermore, make sure you keep all your receipts in a centralized area, i.e. scanned into an electronic folder.
3. Where are you at with any approvals with the local jurisdiction?
Most time the lender is concerned that the city, or county, will decline the planned use. This, in turn, would cause the lender to be stuck with an unusable project; henceforth it could put the lender in a problematic status with the regulatory authorities. Make sure you have had the appropriate conversations with local authorities, architects, etc. Gather the appropriate evidence to help substantiate the case for the project being approved. Ideally, you will have appropriate documentation that shows you are already approved.
4. What are the time frames for each phase of the project?
As you well know, development/construction projects can take long periods of time. When will you go to planning and zoning? When will you have full sets of drawings from the architect? When will the water/sewer be in place? When will utilities be in tact? When will you be able to pull permits? How long are these permits good for? Etc.
Investment (Apartments, Office, Retail, Industrial, Self Storage)
1. How does the rent roll look?
The rent roll shows a lender who the tenant is, how much of the space they take, what they pay in rent, how long they will be there, etc. Bottom line is the lender cares about the tenant, because that is their primary source of repayment. Are all the tenants’ leases renewing in the next year; could be a problem. Is one tenant taking 60% of the space; say goodbye to the cash flow if they leave. Is the tenant in an industry that is shaky? Be prepared to answer these points of concern for the lender.
2. What is the historical cash flow on the property?
History, for a lender, can be a very big predictor for the future. They want to see what the taxes, insurance, common area maintenance, repairs and maintenance, management fee that it takes to operate the property. In many instances you can offer this in the form of a tax return (ideal) or a profit and loss statement. Cash flow, cash flow and cash flow is the key for the lender to make, or break, a deal.
3. Where is it located?
We’ve all heard the saying “location, location, location” for good real estate investing. Is the property in a rural area, or a metropolitan area? Believe it, or not, this makes a huge difference in getting approved, or denied. Small towns raise risk flags for lenders, as they are typically the first one to die off in a recession. Furthermore, is the property located in a place that someone would have to pack a gun? What is right around you that would support the success of this property? Is it right by a freeway? Do you know the traffic count of this location? Is there a really good retailer right across the street? Gather facts about the area, so you can make the case of why they should lend on this location.
Owner Occupied
1. What is the company’s historical cash flow?
Again, the lender is trying to find out if you have the ability to pay back the debt. They way they look at your business tax returns cash flow is to take your net income, add back rent (if that goes away), add back depreciation/amortization, add back interest expense and any one time expenses. This will give them a pre cash flow available to service the debt payments. The magic number is 1.25 Debt Service Coverage Ratio. This is simply taking the pre cash flow and dividing it by the companies total annual debt payments, including the new loan. Example would be taking a pre cash flow of 125,000 and dividing by the all the debt payments of the company 100,000…end result if 1.25.
2. What is your personal cash flow?
The lender wants to take your personal tax returns and see how much you bring home. They will look at your W2 income, investment income, etc. The goal is to figure out if you have the ability, from your “personal” income, to service your personal debts. What do we mean by personal debts? Home mortgage, car debt, credit cards, student loans, etc. Bottom line is they want to make sure your not having to rob from the business to pay for debts; that your not bleeding with too much personal debt.
3. Are you an expert in this area?
This is pretty simple, but really important, because years behind you shows wisdom. Is this a new space for you, because if so, it shows you haven’t weathered good/bad times. You don’t know the in’s/outs of the industry. The lender wants to see that you know what your doing, or that someone you work with does.
4. How is your credit?
This is HUGE and can be a deal breaker. FICO Score helps, but it’s not enough. Have you had any bankruptcies, foreclosures, short sales in the last 5 to 7 years? If you have, what happened? Did you try to make everyone whole, or just walk away? The lender is looking for character; are you a person that will do whatever to pay people back? If you had some past issues, make sure to document the details. What specifically happened, why did it happen and why will it not happen again?
Why It Matters
This matters for a lot of reasons, but the first one is that lenders aren’t in the business of owning properties. They want to lend money to people that can pay them back. This is why they go through such painstaking underwriting; to assure you can afford to do this. The second reason is that lenders are regulated by governmental agencies. They are not doing all this because they want to be a pain but have to answer to people. There is a lot of accountability in lending large amounts of money, so due diligence is important. It is so serious, that if they don’t document appropriately, they could be shut down. Third is they are essentially your second pair of eyes for accountability. Your perspective should be that this is gift to your enterprise. There are many times we see clients getting annoyed at all the questions, when they should be thankful for the challenge. Push back, and questions, help refine your process and growth.
How Should You Spend Your Time Preparing
This is going to be easy, as it will be a list of things to do, in detail:
Development/Construction
- Have site plans from the architect put together. This will give details of what the site layout is and gives the lender the collateral information.
- Get a “detailed” budget from the contractor. Have all the line items detailed out. In a perfect world you would have a final bid/contract signed with the contractor.
- Conceptual plans would help to show what the buildings will look like. Lenders like visuals, so give them the best layouts.
- Timeline and schedule, which provides draws from the contractor and the estimated completion. Make sure you offer sections for Phases, if you are doing the project in phases.
- Provide financials, and appropriate bonding information, for the contractor. The lender will need to underwrite them to make sure they are financially stable.
Investment
- Get your personal financial statement put together. Don’t just slap numbers on there, but have supporting notes, which explain what things are. Integrity Capital, LLC have forms that can help you.
- Provide detailed historical financial statements showing income and expenses. Ideally you will offer 3 years, along with an year to date profit and loss statement.
- Give a rent roll that shows suite number, tenant name, square footage, % of CAM expenses allocated (if applicable), start and stop date of lease, extension options, etc.
- Color photos go along way in showing the condition of the asset, so have inside, outside and surrounding area photos. It would also help if you had an aerial photo to give a 30,000-foot sketch of its proximity to other demand drivers.
Owner Occupied
- Get your personal financial statement put together. Don’t just slap numbers on there, but have supporting notes, which explain what things are. Integrity Capital, LLC have forms that can help you.
- Have 3 years, if possible, of profit and loss statements together, along with a year to date for the lender. Your accountant/CPA should have this prepared. Make sure that they line up with your tax returns.
- Provide 3 years, if possible, of corporate tax returns. The lender will focus on what is on the tax returns, as opposed to just the P&L statements. Lenders will not care if you say "we wrote everything off in the business", which is another way of saying "I cheated so I didn’t have to pay taxes."
- Fill out a business debt schedule, which we can provide. This will tell the lender what loans you have, who the loans are too, what the payments are, when they expire and what the debt is tied to.
- Provide 3 years of personal tax returns and offer the whole tax return; not just the first few pages. They want to see all the schedules and K1’s. Make sure they are signed and dated.
- Offer a resume of you, and your company. This is the time to sell yourself and all your credentials.
Remember that qualifying for a commercial mortgage is not easy, but it is worth it. Getting a good loan will take a lot of work but will pay off in the years ahead.