| COMMERCIAL PROPERTY
Commercial property, usually 5 plus unit apartment buildings and office buildings, must be carefully analyzed to determine whether one is an appropriate purchase for you. The following are terms are typically used in commercial transactions and are important to understand when analyzing the appropriateness of a building for you.
DEBT SERVICE RATIO
This is often the first analysis a mortgage lender makes when considering a loan application on a commercial property. The Debt Service Ratio or Debt Service Coverage Ratio (DSCR) is a formula used to determine whether a property will likely generate sufficient income to meet the mortgage payments and retire the loan. This number is computed by dividing the Net Operating Income (NOI) by the annual mortgage payment. The resulting coverage ratio required by lenders will vary some but basically they are looking for a number greater than one; 1.15-1.30 depending on the project and the lending institution. The additional fraction gives lenders comfort that in the event the project NOI slips, there will be enough extra to meet the loan payments.
NET OPERATING INCOME
This is the income remaining after deducting operating expenses from Effective Gross Income (EGI). Operating expenses include but are not limited to repairs and maintenance, but not capital expenditures like additions, roofs and driveways, taxes on the property, insurance, utilities, and maintenance. EGI is income minus a vacancy allowance which is expressed as a percentage of the yearly GRI.
GROSS RENT MULTIPLIER
The Gross Rent/Income Multiplier (GRM) is a way to value property. It is determined by dividing the sales price by gross income. Thus if a five unit building sold for $2m and the gross income was $192,000 then the property would have a GRM of 10.42. Since the sale has not yet actually occurred, comparable properties are used to determine a for sale property´s GRM.
CAP RATES
The Cap Rate or Income Capitalization Rate is another method to value commercial property. Here the NOI is divided by the sales price. Again, the subject property has not yet sold so the best comparables are used. For example, should the comparables show that the estimated value is $2m and the NOI is $186,000, the cap rate would be .08.
LOAN ISSUES
Mortgage loans on commercial property essentially are much like residential mortgage loans yet some differences apply. For example, commercial lenders will often offer a hybrid loan. These are loans that combine both an adjustable and fixed rate. A fixed interest rate will be applied for the first part of the loan, between 3-10 years in most cases, and then become an adjustable rate loan for the remainder of the loan period. As with any adjustable rate loan, margins, caps, life caps and payment adjustments should be fully identified up front. Also, look for whether the loan being offered has a Recourse Clause. If so, the lender can come after you personally should there be a default and a deficiency judgment obtained. Always have all terms in writing before you proceed.
Verbal representations as to costs and terms are little help after the property is purchased and the loan is issued. An accountant with commercial property experience is well worth the expense.
We would be pleased to discuss with you your objectives in the commercial property area. |