JF977: Commercial Loans 101!
He wrote a book all about it, so today get your notes ready for commercial loans. From being approved to closing the deal you will understand what lenders are looking for in this niche.
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Michael Reinhard Real Estate Background:
– Commercial Mortgage Banker at Texas Commercial Mortgage, LLC
– Author of successful book Commercial Mortgages 101: Everything You Need to Know to Create a Winning Loan Request Package
– Masters Degree in Land Economics & Real Estate from Texas A&M
– Based in Houston, Texas
– Say hi to him at www.texascommercialmortgage.com
– Best Ever Book: Hamilton
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Joe Fairless: Best Ever listeners, welcome to the best real estate investing advice ever show. I’m Joe Fairless and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any fluff.
With us today, Michael Reinhard. How are you doing, Michael?
Michael Reinhard: I’m good, thanks.
Joe Fairless: Nice to have you on the show. A little bit about Michael – he is a commercial mortgage banker at Texas Commercial Mortgage. He is the author of the book Commercial Mortgages 10Joe Fairless: Everything You Need To Know To Create a Winning Loan Request Package.
He’s got his masters degree in land economics and real estate, and he is based in Houston, Texas. With that being said, Michael, do you wanna give the Best Ever listeners a little bit more about your background and your focus?
Michael Reinhard: Yes, Joe. As you mentioned, I received my masters degree in 1989, and I immediately began my career working for savings and loans in the REO department. At that time the savings and loans crisis was at its pinnacle, and basically there’s no lending on real estate in Texas for the most part. I kind of cut my teeth on commercial real estate by analyzing the cash flow, the assets of the bank that were basically in the [unintelligible [00:03:34].20] to get sold. It was the mandate by the Resolution Trust Corporation – the RTC acronym that most people are familiar with that are probably in their 40s and 50s.
That’s where I really learned the analysis of cash flow for all types of properties, so it was a good, well-rounded, quick education in all types of commercial properties. It was from multifamily, to office, to warehouse, industrial, self-storage and even MUD receivables.
Joe Fairless: What are MUD receivables?
Michael Reinhard: MUD is an acronym for Municipal Utility District. For example, if you’re outside a subdivision and a growing community is outside the reach of the main city’s water facilities… It’s almost like a privately-run organization to provide water lines to the community. Usually the taxes are a lot higher. There’s like a board — it’s kind of like a quasi-government agency that’s privately run and provides the utilities to that area because the city hasn’t been able to get out that far.
I don’t know exactly how they were set up or the history of them, but when the developer would develop a subdivision for single-family homes (or even a multifamily property), you’ve gotta go to the MUD board to get a approval for the capacity you’ve got, to determine if there’s enough capacity to build a 200-unit apartment complex. You’d have to get the board to vote on it. There were some politics involved… But when you do that — and let’s say… Because I mentioned that at the bank, when the savings and loans crisis hit, and the recession, a lot of these subdivisions were abandoned, and there was a lot of money spent on these water utility — I don’t know if they were just water taps, or sometimes water plants or water pumps that were just sitting out there… They had value; the bank owned those, and we were just trying to determine what the value of those was at the time. That was kind of interesting.
With that said, in the early ’90s there were a lot of ex bankers, a lot of ex real estate people in the late ’80s or the ’90s that were working these different failed savings and loans; they were all being propped up by the selfless bailout government financial rescue… So when all the assets were sold, everybody was kind of losing their jobs, worked themselves out of the job, so there’s just a lot of real estate, analyst people in 1993-1994, and then we had another recession in ’94… That’s when I transitioned into working as an analyst on the mortgage banking side, because around ’94, ’95 this new conduit lending – it’s called the CMBS Loan… CMBS is a commercial mortgage-backed security; it’s the same thing as a residential MBS… That was kind of a new vehicle to provide commercial real estate loans to commercial property investors.
I started off as an analyst at a large commercial real estate firm called [unintelligible [00:06:33].15] which is a national firm… That’s where I had to shift a little bit my real estate career from just more of an analyst and selling assets to now getting on the mortgage side.
It was a good move, and I learned the conduit lending along with Fannie Mac and Freddie Mac agency lending… I spent years as an analyst, an underwriter, working for various banks like Bank of America, John Hancock Life, and some other smaller Texas banks… Then I finally decided in 2009 when the great financial crisis hit – of course, so many people got laid off, there just wasn’t any lending – to take all the expertise I had, venture out as an independent commercial mortgage banker. That’s when I wrote the book.
That’s kind of the genesis of my current position as a commercial mortgage banker, because I’ve spent years and years as an analyst, underwriter, and I felt at that point there’s no place to go at the bank. I was never really an executive or a major stockholder of a bank, so I thought there’s really not much more for me to do or contribute at a bank, and I would prefer to be able to help investors with all types of financing.
As a broker, if one bank says no, then I just go to the next bank or the next type of lender… So it’s more exciting, it’s more challenging. Every deal is different, there’s not one commercial real estate loan that’s alike, unless you’re doing the same old cookie-cutter Fannie Mae loan. That’s how I came about working for myself; I’ve got clients in California, in Florida, in Texas, I’m doing some loans in Indianapolis… I can do loans nation-wide.
I normally don’t do anything in California, because there’s just an inordinate number of brokers there, and I don’t really know the market in California. It’s a different market, and there are some licensing requirements. Texas is big enough, there’s plenty of real estate here.
Joe Fairless: Yes, there is, that’s for sure. I have purchased your book right before we got on the call… I bought your book “Commercial Mortgages 101: Everything You Need To Know To Create a Winning Loan Request Package.” I’m very intrigued by this, and I’d like to spend some time talking about the content of your book.
For a Best Ever Listener who has some single-family home properties and maybe a small multifamily property, but now they wanna go a little bit larger, and for the sake of simplicity, let’s say it’s multifamily… They wanna go a little bit larger to, say, a 20-30 unit property. What do they need to know about commercial loans, in particular as it relates to getting a package together for the lender?
Michael Reinhard: The first thing I’d like to emphasize is that a commercial real estate loan is an entirely different industry than a residential loan… A residential loan meaning either a homeowner loan or even a 1-4 family, whether it’s a duplex, triplex or fourplex. Everything you know about and any experience you have with that type of loan – forget about it. Don’t even try to make a comparison. It’s a different industry. So when you’re attempting to buy a 5-unit, or a 10-unit, or a 20-unit, as you’ve suggested, often times you have to deal with a local bank or maybe a national apartment lender.
Credit scores, for example, would be the first place to start. It’s always good to have a good credit score. It’s not all that critical, where residential mortgages it’s almost like it literally hinges on your credit score only, and of course income, but with commercial real estate loans credit score is not the top consideration, it’s not the most important. Then the next thing that a lender would like to see in an investor is net worth and liquidity. Net worth is, obviously, the difference between your assets and liabilities, and they like to see a net worth equal to or greater than the loan amount.
If you’re wanting to buy a $1,250,000 apartment building – I always like to use that number – in an 80% loan, to be a million dollar loan, they would like to see your net worth equal to a million or more. It is not always the rule that you have to have a million dollar net worth; you could have $800,000, $600,000… Because if you have a lot of income, if you have a good income, if you have a high salary or a W2 salary, or you’re self-employed and you make a lot of money, net worth is not all that important. There’s some mitigation for the net worth.
Then the liquidity is really important. Yes, you have to have enough money to put down; in that situation you’d need $250,000 to put down… But if that’s gonna use up all your cash, just to get into that deal, the lenders will look upon that as a little weary, because you have no cash left. They don’t like to see someone use up all their cash after a closing and then not have anything for an emergency such as a $10,000-$20,000 deductible for an insurance claim; let’s say you have a fire immediately after you purchase the apartment building – which has happened to one of my clients; within 3-4 weeks he had a fire after just closing on a 44-unit apartment complex. He had to make a claim, and the lender wants to know that you have enough cash to make the claim and get the property fixed, and get it re-leased, or re-tenanted and cash-flowing, sufficient enough so it doesn’t put your payments in jeopardy and putting any hardship on you.
Joe Fairless: What type of liquidity do they look for?
Michael Reinhard: It varies between lenders. The general rule is 10%-20% of the loan amount. If you’re wanting to borrow a million dollars, you have to have at least $100,000 after closing; $150,000 or $200,000 is even better. Sometimes they use 6-12 months’ worth of principal and interest payment. If your mortgage payment was, say, $10,000 a month, they’d like to see $120,000 or so in liquidity. Those are the general rules.
Then the next would be ownership experience. Owning a duplex, or three or four single-family rentals, or maybe 10 or 12 (you could even have 30 of them) – that’s even better if you have a large portfolio of single-family rentals. But if you’ve only had one or two, and maybe a couple of duplexes, that’s not the same as a multifamily, because it’s a little bit different animal.
Anywhere between 5 up to maybe 50 units – they pretty much allow you to self-manage the property because there’s not a lot of third-party management companies that would want to take on a management of that size; it’s just too small and they don’t make enough money to do it.
Because the lender knows that it’s difficult to find a third-party management company and they know that the investor will be attempting to manage the properties themselves, they want to see “Hey, what do you know about leasing, and doing the credit checking, verifying employment and background, the criminal background?” and just qualifying tenants and management of the property. They’re gonna wanna know if you have some experience in managing the property. You could have owned properties and had some third-party management – that’s fine, too.
So ownership experience and management experience. Ownership experience is a little bit more important than management because they know not everybody manages their own property and it’s not that important.
So those are the five: net worth, liquidity, ownership experience and management experience, credit score – that’s six. Income, in terms of whatever you are – a W2 employee or self-employed… They also wanna know if you have a portfolio of properties; they wanna look at your global cash flow, how much cash you earn after debt service… Because any excess cash flow after debt service meaning you’ve got your net operating income, then you have a principal and interest payment to the lender, and the rest is taxable income. That’s pre-cashflow — not necessarily pre-cashflow, but that’s taxable income that you have left over that if you’re experiencing some hardship on one property, you can then move that cash around to keep all your debt service intact.
A lender likes to see your global cash flow, and that would be your income in whatever profession you’re in, or if you’re in real estate full-time, they wanna just see your overall cash flow. There’s really no ratio on that. People ask me about your debt-to-income, what is the residential ratio…? It’s your income-to-debt, or is it debt-to-income…? They don’t really use that in commercial real estate. They just look at the property’s loan-to-value and the debt coverage ratio, meaning how much does the net operating income exceed the monthly principle and interest payment.
And the PITI is not applicable. So when I say debt service, it’s not principal, interest, taxes and insurance. In commercial real estate it’s just PI – principal and interest. Because in multifamily investing, as part of your operating expenses, it includes property taxes and insurance. It’s always an operating expense, it’s not a part of your payment to the lender, because those may be ESCROWs in those 1-4-family… It’s still an operating expense, but they collect them. And it’s not to say that the commercial lender doesn’t ESCROW for taxes and insurance – they do, but when they’re calculating all their ratios, your debt coverage ratio, that’s only principal and interest.
Joe Fairless: What are some immediate disqualifiers that a commercial lender will have?
Michael Reinhard: Generally, the first thing I like to ask is — an extremely low credit score is… I would say below 600 will raise some eyebrows or will require further explanation. When you get into the 500, that’s difficult.
The next would be any bankruptcies, and usually anything older than 10 years is okay. So any bankruptcies less than 10 years may disqualify you. And then foreclosures – any type of foreclosure and any summary judgments, and that could be for any reason. Any summary judgment, which is basically a court order settlement in which somebody has won a claim against you for any reason, any business, lawsuit, any real estate, and which you’ve obviously not been able to settle or pay, and therefore it lines up on your credit report… Because often there’s no real explanation of that on the credit report, there’s not much detail, so you then have to ask the credit applicant “What is this? What was it for?”
And usually, another thing is self-employed people who are living off the cash flow of some real estate investment. If you have one or two or three single-family rentals and that’s all you have, but that income is what’s supporting your family, that doesn’t bode too well for the lender… They see that you’re generating enough income obviously to support your family or your house (even if you’re single), but it doesn’t leave anything to service the debt of another loan or to give you any cushion in the events of some financial hardship. It’s just too tight. They like to see people who don’t have to depend on their commercial real estate investments or even their single-family real estate investments, they don’t have to depend on it to pay their bills.
Now, if you have a huge portfolio and you’re making 200k/year off your real estate, that’s fine. But if you’re just barely getting by and you’re trying to buy your next deal, that’s a little bit of risk to the lender. So self-employed people have to be pretty well established.
Joe Fairless: What type of loan-to-value ratios should we project when we’re initially running numbers on a stabilized multi-family property of about 30 units?
Michael Reinhard: 80% is the standard loan-to-value for a multifamily apartment building. Anything commercial-wise – an office building, a retail center, industrial warehouse, a medical office – is 75%. But there are some exceptions on the 80% for multifamily, and that would be depending on the debt coverage ratio – how much the debt coverage ratio is, how high it is, the income of the borrower and the strength of credit worthiness and financial strength of the borrower.
If you don’t have much net worth and you’re trying to do your first deal or your second deal, they may say “Well, we’re not gonna provide that much leverage. We’d rather limit out exposure to 75% and not 80%.” So if all looks good – good income, decent net worth – you can always pretty much get an 80% loan. But there are extenuating circumstances that may limit to 75%. In each deal, all of the information has to be considered: the borrower information and the property information… And the age – it could be an older property in a rougher neighborhood. It’s really subjective, so it’s up to the chief credit officer, chief lending officer to determine whether they can go that high.
Joe Fairless: Michael, what is your best real estate investing advice ever?
Michael Reinhard: I know this sounds simple, but not to overpay for properties based on when cap rates are trending down. Right now, and what’s gonna happen to my clients that have five-year money with banks – interest rates are gonna go up, and cap rates that are now in the 6%-7%, if they don’t go up with interest rates, a lot of borrowers are gonna be stuck trying to refinance a property five years from now at a much higher interest rate, and I’m talking about 7%, where now the lender is making more money than the investor is.
So it has to do with buying at the right cap rate. Don’t buy into this notion “Where else are you gonna put your money?” 6% is a good return, but you can get burned in real estate using that logic. So no matter how badly you wanna buy a property and how you wanna get into this market and get in the game, patience pays off to make sure you start off with a good at least 7,5%-8% cap rate. Because interest rates are gonna go up, and a lot of people are going to be in shock three and four years from now.
If you don’t have rental rates that are increasing to increase the value of the property, it’s gonna be a little bit more difficult to refinance. And what’s gonna happen, your return on your equity is going to plummet if you had paid too low of a cap rate in a rising interest rate market.
Joe Fairless: Good cautionary advice, that’s for sure. Thanks for sharing that. Are you ready for the Best Ever Lightning Round?
Michael Reinhard: Absolutely!
Joe Fairless: Alright, first a quick word from our Best Ever partners.
Joe Fairless: What’s the best ever book you’ve read?
Michael Reinhard: Hamilton, I just finished it… Alexander Hamilton.
Joe Fairless: Oh, yeah…
Michael Reinhard: I just finished reading it, and I was like “This guy is a genius!” He’s a financier; this guy was a genius. He created our financial system.
Joe Fairless: There’s a couple books out about him… I’ve got a gigantic one that I’m about 20% of the way through; I’ve been working on it for about six months. [laughs]
Michael Reinhard: Yeah, Alexander Hamilton is the name of the book… Ron Chernow is the actual book that inspired that musical Hamilton.
Joe Fairless: Okay, got it.
Michael Reinhard: It’s 800 pages long. He created our financial system, he created basically our mortgage system… It’s amazing. This guy was [unintelligible [00:23:15].24] He died at the young age of 49. He just wasn’t given the credit that he deserves.
Joe Fairless: Best ever transaction you’ve done?
Michael Reinhard: I placed some preferred equity for a group that was buying a multifamily property in San Antonio. They had the deal under contract for a long time, and the investors were just coming up short — well, they weren’t just coming up short; they were about 3-4 million short of raising their equity, and they had literally three weeks to close. I was able to bring in that preferred equity lender that provided 3.2 million dollars in equity that was able to salvage the deal; earnest money was hard at risk, and I made a handsome fee on 3.2 million dollars.
Joe Fairless: What type of rate would that preferred equity partner charge?
Michael Reinhard: It was 15%, but there was no carried interest, or what they call “No promotion”, meaning that they had a superior position of preferred equity versus the common equity, but it was priced like mezzanine financing, which is like a second loan. That means they’re just saying, “Look, all we want is the 15% annual return. We don’t get any of the upside, we don’t get any of the profit. You sell it, you finance it… We don’t get any more. We’re not going to increase our return”, where a joint venture equity investor would say, “Okay, I’m going to get a 8% preferred return every year, and then I’m going to get 50% of the cash flow when they sell it.”
Well, then if you do an internal rate of return calculation over that three, four, five-year period, you could have wound up making a 20% internal rate of return. Well, it was simple; it’s just a plain, non-compounding 15% return on the investment. If they invested three million, they’re gonna make $450,000, and that’s all they get. After the another three years, they just get their 15% for over three years. They don’t get anything more and nothing less.
Joe Fairless: That was a three-year term…
Michael Reinhard: Yeah, it was to be a three-year term and they had an option to extend, so if they needed more time, they would have given them another year.
Joe Fairless: That’s interesting.
Michael Reinhard: Yeah, so they wouldn’t have made any more or less; they would have gotten their $450,000 for those three years, and no matter how much the sponsor — if they made a two million dollar profit, the preferred equity lender would not get any of that.
Joe Fairless: Did they buy this property all cash?
Michael Reinhard: No, that’s why it was the best deal ever, because there was an existing HUD loan that they were assuming. And there were some complications under any kind of a Fannie Mae, Freddie Mac or even an FHA HUD loan, because they don’t allow hard second liens, they don’t allow a pledge of the partnership interest that mezzanine financing usually involves. This lender is familiar with all of those loan covenants and requirements, so they’re able to structure the partnership agreement, basically amend the partnership agreement to secure their investment right… Because they weren’t taking an ownership interest, but they have certain rights and remedies, and if they didn’t pay back that 15%, then they could essentially take over — really, they actually provided credit enhancement to the transaction, because the company is well capitalized and actually is probably worth more than the investor sponsorship. So those first lien lenders – they’re fine with that.
So time was running out, the approval of that assuming that loan was running out… This group was able to work through the terms of the partnership agreement and within three weeks analyze the transaction and make a decision and fund it in three weeks. It was actually less than that, because the borrower was really becoming a little difficult to deal with because they were making some demands, and I said, “Don’t look [unintelligible [00:27:22].21] I said “This is a good deal, quit pushing back.”
Joe Fairless: Yup. What’s the best way you like to give back?
Michael Reinhard: Education. I’m always helping people. I do my own tax returns, so I have a lot of people that have nothing to do with real estate, but just sharing information, networking and sharing… I believe that sharing and helping people in areas that you have a specialty and knowledge in — I always find it rewarding to share my experiences and help people. I believe that if I can help you make money or help you achieve your goals, some day you can reciprocate. When someone calls me and asks me for advice, I don’t hurry them off the phone. I’m glad to help someone or refer them to somebody else that could help them… Because I know how frustrating it can be.
I had some accounting questions and tax questions; I was so frustrated with the actual CPAs that I felt like they didn’t know what they were talking about. I actually called the IRS and did all the research and I figured out how to solve this problem of mine. Now, anytime that you spend that much time and effort, then at that point you’ve become an expert, because now you can share that and save somebody else the grief, or getting wrong information. There’s plenty of wrong information out there.
Joe Fairless: That’s a perfect segue into — not the wrong information part, but the reaching out and talking to people… That’s a perfect segue into the last question – where can the Best Ever listeners get in touch with you?
Michael Reinhard: They can reach me at my website at www. texascommercialmortgage.com. I also have a website for my book – www.commercialmortgages101.com. So you can go to my website, texascommercialmortgage.com and I have a link to the book’s website, and I have a phone number on my website. They can call me, or you can send me a message from my website, or give me a call.
The book is available also on Amazon and Barnes & Noble, but I do have a website, and if you order the book from my website, I’ll actually mail you a signed copy. If you order it from Amazon or Barnes & Noble, I’m unable to sign it.
Joe Fairless: Michael, thank you for being on this show, sharing your best advice ever, talking about the differences between commercial and residential loans, as well as the things we need to make sure we have taken care of prior to applying for a loan. One is credit score 600+, two is net worth of equal the amount of the loan, three is liquidity 10%-20% of loan amount after closing, four is experience of the owner (our experience), and five is our global cash flow. Thanks so much for laying that out there so clearly, as well as talking about the things that would dissuade a lender from lending to you… You mentioned a list of those as well. And then the interesting story about the 15% interest equity partner for that three million dollars in a very short amount of time.
So thanks so much for being on the show… I hope you have a best ever day, Michael, and we’ll talk to you soon!
Michael Reinhard: Thank you, Joe!