Today we will learn how you can get a commercial loan as a first time buyer and operator, what is debt service coverage ratio, what counts as assets when you are getting a loan, what are deal killers when getting a commercial loan, and what are some things that you should keep in mind about your loans in case our economy takes a turn.
We are interviewing Blake Janover, the founder and CEO of Janover Ventures, a commercial real estate and multifamily capital markets advisor focused on providing senior debt for commercial real estate. He has underwritten and advised on billions of dollars in commercial real estate over the last 15 years. He is an office member of the Forbes real estate council and has been published in Forbes, Housing Wire, Multifamily Today and other industry journals.
Let’s go over the basics of commercial real estate financing, especially for first time buyers. Can they get a loan, do they need to have a job, does the credit score matter as much as residential, what’s the minimum down payment?
The answer is yes. It’s considered a credit factor, a risk factor, when an underwriter that analyzes credit looks at a deal and says “This is your first piece of commercial real estate” this is higher risk, but there are ways to mitigate it. One way to mitigate the risk is to add a partner that’s highly experienced, I think it’s great advice. It’s not just great advice because it’s what the lender wants, but generally speaking there’s a reason the lender wants it, and it’s imprudent to enter into a new industry without experience and not think that there are a lot of things that could go wrong that you don’t know about and that’s what having an experienced partner is about.
In some cases you can offset experience with having an experienced third party property manager that has a demonstrated track record of managing similar properties in a similar sub market, and lenders will look at other things in order to offset certain risks such as a larger down payment, for example. I’m definitely of the opinion that an experienced partner is super valuable on a first deal, but if you can hire a great shop to manage the property that has a great track record and maybe pony up some extra money, you will ultimately get a loan if the property is credit worthy. Speaking of credit worthiness, you asked me about how this differs from residential there. Our strength is in loan amounts over 2 million for general commercial, and over 1 million for multifamily. This debt is non-recourse. It means you’re not signing a personal guarantee. Your loans are non-recourse subject to standard carve outs. Carve outs being, if you do something materially dishonest or fraudulent, it would trigger a personal guarantee, but otherwise it’s just about underwriting the property.
In residential, job, job history, personal income, these things mean something, and in bank underwriting, global cashflow is a factor, but for commercial real estate capital markets like CMBS loans, these things are not factors. Credit score is a little bit of a factor. Generally, you want to have a credit score better than 640 or 680 credit. In many cases it’s not a deal killer. Personal tax returns aren’t taken into consideration at all for small loans over a million or 2 million, but net worth and liquidity is, and that’s a function of the lender wanting to see that the key principles, the KP’s, have the financial wherewithal to weather a storm and that’s not derivative of personal net income. That’s derivative of how much cash you have in the bank. In these ways, it’s very different. The primary underwriting metrics in residential is probably DTI (debt to income ratio) and LTV (loan to value). LTV transcends industries, it matters in commercial also, but the real metric in commercial real estate is your DSCR, your debt service coverage ratio. That’s a comparison of your NOI versus your debt payments and generally lenders will want to see that you have a 1.2 minimum debt service coverage ratio. This changes product by product, and asset class by asset class, but 1.2 – 1.25 is a good indication of what most lenders will look at. And then there are other complicated things, like debt yield and loan constants.
When you say 1.2 – if I get a $1 million dollar loan, does that mean that I need $1.2 million in my bank account?
No. From a net worth and liquidity perspective, lenders generally want to see that you have a net worth greater than the loan amount. That’s all your assets minus all your liabilities. So if you’re borrowing a million dollars, they want to see that you have a better than a million dollar cumulative net worth among all the guarantors or carve guarantors. And this isn’t a hard and fast number. Liquidity is generally 10% but I’ll talk about a deal a little later where we went way below that. So these are not hard metrics. Debt service coverage ratio is a hard metric. A good example is if your monthly debt payments to your lender are $10,000 a month, your lender will want to see that you have net operating income no less than $12,000 a month. That 12,000 representing 1.2 multiple of the 10,000 debt payments.
In terms of assets, does that include the existing property? Let’s say we have 30% down, would that 30% down count?
Yes, that’s your money. On a purchase and on a refinance it’s based on the as is value of the property, but absolutely. It’ll be the cumulative net worth of all the key principles in the borrowing entities and usually borrowing happens in an SPE, or an SAE. SPE means special purpose entity. SAE is an acronym for a single asset entity, they’re both the same thing. It’s an LLC that only owns one thing and only takes out one loan. So yes, that’s including your money, your assets, and those of all of the key principals that are signing the loan are included in the net worth and liquidity underwriting.
What are some typical deal killers for loan applications?
We don’t generally have any deal killers once we’ve “apd” a loan, once a borrower signs an application with us, because we screen deals pretty heavily upfront. I’ll talk to you about some pre-application killers because we do really good due diligence post application. One of our biggest deal killers prior to an application is unrealistic expectations. We get inquiries that are not based in reality: “I’m buying a property for $5 million, I want to borrow $6 million”. Okay, me too, let me know when you find that loan. Sometimes folks are looking for equity and we’re really focused on senior debt. A big pre-application and post application deal killer is nondisclosure, principals that are not telling us all of their dirty little secrets and then it comes out later and it hurts everybody. I’m a big believer in just tell us everything upfront and we will either figure out a way to make it work or put a bullet in it early, but everything comes out in the wash.
If you don’t tell us now, it’s going to come through later. The underwriting is really, really in depth and everything always comes out. That’s the only thing that’s killing it before and after. Other little deal killers are net worth and liquidity, experience, which you’ve already talked about. “It’s my first deal”. That’s okay, but what are you doing to compensate for that from a credit perspective? What are you bringing that offsets that credit risk? Another one is weird asset classes “I’d like to borrow money for an aquarium, like a SeaWorld. We’re gonna get a killer whale”. Okay, maybe that’s an SBA loan, but it’s not us, and it’s not most conventional lenders. Most conventional lenders are going to look for conventional asset classes: office, retail, industrial, hospitality.
The thing that kills or hurts deals that have already been apd besides surprises that are hidden, are surprises that aren’t hidden. Things like title issues that nobody knew about. One thing that can be unplanned for that should always be planned for, on purchases especially, is underwriting the real estate tax number. If it’s not a triple net property, you have to be really careful to look at the new tax. You’re buying a property from a guy that bought the building in 1950 when it was worth $25 and he has been keeping his tax bill low, and now you’re buying it for $10 million. Your tax bill is going to change and it’s going to change meaningfully. So it’s important to underwrite to the new tax number.
Thanks for mentioning this, we try to mention it a few times so people can really make sure that they look at that because it can definitely be a huge deal killer.
It has not only to be considered from a cashflow and a net operating income perspective, but it also has to be considered from a valuation perspective. You’re building a value off of an income capitalization approach. You’re taking the net operating income and you’re applying a cap rate in order to come up with a value. If that real estate tax number is going to go up and your NOI is going to go down cause you don’t have a true triple net property and you’re not passing these expenses off to the tenants, your valuation is going to tank. You’re not getting a good deal. Always calculate a new tax number. Worst case scenario is the best way to plan.
Even if it is a triple net property, some tenants have pre-negotiated that their tax cannot be increased by too much upon a sale. It’s also very important to take a look at the lease and what that tenant has agreed to.
That’s a great point. You’re 100% correct. That’s the the value of the estoppel letters. At the end of the day, some people overlook it, so get a good attorney that has experience with commercial real estate and hire people that you trust, or that come from referrals, or that have a really proven track record to help protect you from variables like this. It’s one of the many examples of why experience matters. If you don’t listen to this podcast and it’s your first deal, you may miss something like this that somebody else wouldn’t miss. Just like you said, it’s a NNN lease that I have with this tenant. Well, you know they’re capped at 10% per year and your real estate tax number went up 300%, you’re going to taste that.
And even if their lease does not say anything about a cap in the tax increase, if you have a coffee shop as a tenant for example, they could not afford the increase, so they’re just going to go out of business. It’s really important they look at all of these things. Let’s go over a deal that you’re either currently working on that is nearly approved or let’s just go over an example of a deal that you have recently worked on.
I’ll talk about a funky deal because we’re navigating it now. I don’t think we’ll close it tomorrow, but we’ll probably close it early next week. It’s approved, but it’s been an adventure. This deal is a couple of hundred units in California. It’s a fractured condo, meaning that the owner owns 52% of the condos in a condominium complex, so he has the majority and he controls the HOA, but he doesn’t have enough to qualify for an agency loan, Fannie or Freddie, or regular multifamily debt. It’s treated as a one off type of commercial deal. We faced all kinds of challenges including the tax number, which is one of the reasons why I bought it up, it hit the NOI, the net operating income, which hit the debt yield, which hit proceeds, meaning the total loan amount.
This is a $22 million loan, 10 year fixed, 30 year amortization, non-recourse with five years of IO, interest only. I don’t recall leverage, but I think it’s probably between 70 and 75% LTV and we got several quotes on that deal and we went with the most aggressive quote. One of the adventures has been in the CMBS market. CMBS lenders, before they securitize a loan, have to find a BP’s buyer and institutional investor to buy the top higher risk piece of the debt, and this particular lender struggled with finding a BP’s buyer. But it is an example of a reason that if you’re going to get a CMBS loan and you have anything that’s a little quirky, you do want to try to get in bed with a lender that’s buying their own BP’s and there are a few guys out there that do it. That’s an example of one deal that is approved that has had some adventure and we’ll close it hopefully in the next day or two.
How many lenders did you go to in order to get this loan?
Sometimes we just know exactly who to go to. In this case, because of the one off nature of the deal and some nuances to it, we probably went to 10 big institutional lenders, like Deutsche Bank and Citibank, to their CMBS department and we probably produced five competitive quotes. That’s atypical for us because we usually have a pretty good idea of who to go to, and what everyone’s terms are going to be, particularly on multifamily. We know the commercial market really well, but it’s a smaller space with less players and with more defined boxes. Commercial just broadens up a lot and sometimes we have to throw more than one dart.
What are some important things that us investors should keep in mind with their loans as we prepare for a possible recession?
There are two scenarios. Scenario one is I’m getting a new loan or I’m buying a property, and scenario two is I’m refinancing. If you don’t have more than five years left, or three years left on your loan, you may want to consider refinancing to a longer term fixed rate loan. For new loans, you want a longterm fixed rate loan. I’ve been through cycles and I’ve been on the receiving end, not in a good way, unfortunately. Speaking from experience, long term fixed rate, non-recourse loan, amortization, assumable debt is what you want. For commercial, you want to get 10 years fixed, for multifamily, you want between 10 and 30 years fixed. This is if you’re a long term investor, if you’re a merchant builder, you’re flipping things, then you’re going to ride the tide in both directions. Tread carefully. You want your debt to be non-recourse and with carve-outs. That means that if something goes wrong, the lender can’t come after you personally, they can only take back the property.
With a looming recession on the horizon, some borrowers and investors may want to consider that even though the highest leverage provides the best cash on cash returns, it also is the highest source of risk in an economic downturn because your ability to service the debt becomes severely hamstringd by really small, even incremental hits to the economics of the property, like rental income or vacancy. My advice is if you’re going to weather the storm, and you’re a longterm investor, you want really long term fixed rate, long amortization to improve cashflow, non-recourse debt.
What is the best way for people to find really good lenders?
Whether you’re buying your first retail center or developing 1,000 unit mixed use property in an urban infill environment, most folks hire an experienced financial intermediary, and that doesn’t mean ask your residential mortgage broker to find a commercial loan for you. Even guys like Related Group, which many people will know of, hire really smart capital markets advisors to help them arrange the most competitive possible financing for their deals. It’s important that you choose someone that’s very experienced, preferably if it’s a referral or if you’ve worked with them before, or they have a proven track record. But the smartest thing to do is to hire a super experienced capital markets advisor, tell them about your deal, the good, the bad, and the ugly, and see if it’s a fit for them, or if they can point you in the right direction.
Let’s say someone goes to a meetup, they are really just getting started. They don’t know who to ask and someone does refer them to a good lender. How can that person make sure that this lender is legitimate?
I’d still put a smart capital markets advisor in the middle, they should email us. We’ll at least give them an indication for no fee. “That sounds good, that doesn’t sound good, talk to this person, talk to that person, or, we can help”. As capital markets advisors, when it comes to CMBS and agency debt, we don’t even charge a fee. We have very high volume wholesale relationships with lenders and they have to take care of us and themselves on the back end. I often get emails from either former clients or friends of clients that ask if something makes sense. Does this term sheet look right? I’m always happy to give it a quick look and let you know, on the house. The market is really dynamic, products and options vary by sub-market, by sub asset class. Industrial is not industrial, industrial is mini storage, self storage, flex, cold storage, distribution, the space is just so nuanced. If you have a term sheet, send it over. We’ll take a peak at it. And if you’re looking for a loan over $2 million for general commercial or over $1 million for multifamily, we’ll put it together for you. We’re also pretty friendly with some great advisors on the bank and credit union side. I’m happy to make introductions.
Is there anything else that our audience should know?
There are more options than you know, approach it carefully. Do your research, surround yourself by smart people and everything is going to be ok.