Commercial Lending

Many established investors as they reach retirement age may be transitioning from a "hands on" investing style to a more passive investment approach. They may be looking to do less work and yet put some of their capital to work in other properties.

Minority Equity Investor

The current market provides a unique situation where investors with capital can make investments in existing commercial properties and reap large rewards by becoming a minority equity investor.

Many properties that were bought in 2006 and 2007 will not be refinanceable in today's market. This means that if their loan comes due more equity will be required to finance the property or the loan will be in default.

Backed Into a Corner

Many commercial property owners do not have enough cash to pay down the mortgage out of pocket.

Equity investors can leverage this situation to their advantage by providing the necessary capital in return for an equity stake in the deal.

The equity investor is providing the only alternative that some property owners will have to foreclosure.

Don't Get Greedy

Equity investors need to walk a fine line between asking for two much and giving away the farm.

If an equity investor asks for an exorbinant return, the current owner may be offended and walk away from the deal. At the same time the equity investor needs to safe guard their investment.

Commercial real estate investors should look for opportunities to provide this type of equity investment.

Yesterday I spoke with a developer selling medical/dental office. He told me that despite the lack of financing in general, doctors and dentists were still able to find financing through SBA loans.

This is confirmed by an article from NREI Online:

While office building transactions have fallen off a cliff in recent months, one bright spot many industry analysts point to is the medical office building market, where sales typically range from $10 million to $30 million. According to the latest data from Real Capital Analytics, sales of medical office properties totaled $3.3 billion in the first nine months of 2008, a 13% drop compared with the same period a year earlier. But that dip pales in comparison to the 62% dive in property sales for the entire office market in the third quarter.

Imagine that little retail center near your house.You know the one.

It has your favorite coffee shop, the weird home decor shop, a woman’s clothing boutique, the nail shop, and the national auto parts store.

Over the years you’ve seen the stores change. Different shop owners have come and gone. The coffee shop has been there for a while. The woman’s clothing store is only a year old.

As you drive by you notice a “Going Out of Business” sale going on in the home decor shop. You’ve talked with the owner of the woman’s boutique and she is having a rough time making a profit.

If these two stores close their doors, you wonder who is going to fill this space. What is going to happen to the owner of that little retail center? Where will he find tenants?

The Plight of Retail Stores

Americans are spending less money these days. We built our economy upon the model of consumption and borrowed to fuel that consumption.

With the well of cheap financing depleted, spending has come to a screeching halt. Retailers nationwide are taking a hit. The recent headlines have featured the likes of Circuit City, Mervyn’s, Shoe Pavilion, and Linens ‘n Things.

The Pain on Retail Center Owners

When a retail store closes or “goes dark” the landlord will feel the pain of having a vacant store. (Some leases do have a provision that stores can close but while the tenant continues to pay rent.) This means that she does not have as much rental income to pay the bills she faces for owning the property.

How Vacancy and Rental Rates Affect Value

I shared here the most common method to value income producing property. The most important numbers to determine value are Net Operating Income (NOI) and the Capitalization (Cap) Rate.

Rental rates and the assumed vacancy rate will affect the NOI. NOI is then used to calculate the value of the property based on an expected return to the investor, the Cap Rate.

Slight Changes with Devastating Effects

So how would a 10% decrease in rents, a 5% increase in vacancy, and a 1% increase in Cap Rate affect a properties value?

Notice that the value decreases by 26%.

Also notice that the change in the maximum loan amount decreases by $1.08 million. If the borrower needs to refinance under these new assumptions, the borrower will need to come up with over a $1 million to close the loan. The foreclosure process and bankruptcy are not far away.

The Current Credit Crisis

Currently, some institutional lenders have begun to underwrite retail loans along the lines of this scenario. They are forecasting decreasing rents and higher vacancy rates.

Some lenders are incorporating a higher cap rate as well. (One developer I know said that he hasn’t started a retail project unless it underwrote at a 8% cap rate or higher because of historical cap rates, even during the boom times.)

Unless, a retail property absolutely must be refinanced now, the wise real estate investor would be best served to hold off until cooler heads prevail.