Jack Friedman

Today’s Commercial Real Estate Problems

Cause and effect revealed.

May 4, 2009
by Jack Friedman, CPA, ABV

Commercial real estate, unlike residential, has typically been financed with five- to 10-year loans, the lender not requiring amortization or providing a guarantee of renewal. The borrower does not offer a personal guarantee of payment. That makes it vulnerable to foreclosure on maturity.

Most commercial real estate has been initially financed at a 75 percent or 80 percent loan-to-value (LTV) ratio, with the additional constraint of a 1.2 to 1.5 debt service coverage ratio. That is, the first mortgage principal should be less than 75 percent or 80 percent of the property value, and net operating income should exceed the proposed debt service by 20 percent to 50 percent, the ratio often depending on various risk factors in the given type of property.

When lenders had ample funds to offer, however, their due diligence may not have been adequately rigorous. Many lenders’ due diligence consisted primarily of a third-party appraisal, with some allowing the proposed borrower to select the appraiser. Once a loan is originated, many lenders do little to monitor the property’s performance. Lenders are often unaware of problems until default. Non-recourse financing is common. The lenders’ only recourse is to the property, not to the borrower.

The appraisal is often the most critical part of a loan submission package. Purchasers — or those seeking to refinance — may approach appraisers until they find one who is acceptable to the lender and appears to be accommodating of their needs. Thus, the 75 percent LTV ratio could be based on an overly generous valuation.

How the Appraisal Works
The appraiser usually attempts to apply three approaches (cost, sales comparison, income). The income approach is considered the most relevant for income property, so greater weight is assigned to it than to the cost or sales comparison approach.

The income approach begins with an estimate of potential gross income, which assumes that all the rent is collected at 100-percent occupancy. The premise of the appraisal can be based on existing leases (leased fee) or on market rents (fee simple). Tenant percentage rents are included for a shopping center when justified by tenant sales. A vacancy and collection allowance is subtracted. Miscellaneous income (late fees and various charges) is added to derive effective gross income.

Operating expenses are listed and subtracted from effective gross income to result in net operating income. These expenses include real estate taxes, casualty insurance, management, repairs and maintenance, utilities, replacement reserves, and so on. The resulting net-operating income is then capitalized (divided by a capitalization rate) to derive the value estimate. All too frequently, tenant improvements (TIs) and leasing commissions (LCs) are omitted from the process of deriving cash flows because they are not annually recurring.

A discounted cash-flow worksheet may be provided to articulate changes over time for each variable and to specifically provide for a reversionary value. Many analysts will point out that use of a capitalization rate automatically provides for a reversionary value. Despite the need for periodic remodeling, the income will be capitalized in perpetuity when the discount rate is equal to the capitalization rate.

Example: Let’s suppose a neighborhood shopping center physically consists of a 50,000-square-foot grocery store as its anchor tenant, plus 25 smaller tenants of 2,000 square feet each, also totaling 50,000 square feet. Although there is currently a 20 percent vacancy rate among smaller tenants, due to poor prior management, an optimistic appraiser expects a stabilized vacancy rate of 96 percent.

The optimistic appraiser expects that the owner can reduce maintenance and repairs by $20,000. The appraiser does not include leasing commissions or tenant improvements on the grounds that they are not annually recurring. This optimistic appraiser applies a seven-percent capitalization rate, whereas others would apply eight percent. Pro formas are shown below.

Potential gross income
Grocery store at $6 per sq. ft

Local tenants at $10 per sq. ft


Local tenants at $12 per sq. ft

Less: Vacancy and collection
Add: Miscellaneous income
Effective gross income
Operating expenses
Real estate taxes
Maintenance and repairs
Total operating expenses
Net operating income
Leasing commissions
(not included)
Tenant improvements
(not included)
Cash flow before financing
Capitalization rate (decimal)
Value, based on above
Loan at 75 percent

Thus, by making some relatively small differences in assumptions, all causing the value to change in the same direction (upward), an optimistic appraiser can deliver a value at nearly double the amount the property is worth based on actual experience with reasonable assumptions of the future.

Subsequently, even when the property and the market experience no changes, a realistic appraisal of the same property at $4,562,500 will face a debt of $6,707,143 at foreclosure. The 75 percent LTV ratio has become a 147-percent ratio. With small negatives occurring, including a market increase in the capitalization rate, the LTV may become 200 percent (that is, the property is worth only half the debt). This may help explain why the John Hancock Tower — the tallest building in New England — sold in March 2009, for half of the price paid in 2006.

Current Economic Climate In the current economic climate, subsequent events may bring negatives to rent rates and vacancy rates, causing values to deteriorate.

Real-estate owners often look at their property as a cash cow to be milked. After arranging the first mortgage, owners may get a second mortgage or sell the land and lease it back, removing any remaining equity. The increased debt service payments required will jeopardize the first mortgage and potentially wipe out all secondary lenders on foreclosure.

Nonrecourse loan provisions and capital structures that avoid personal liability facilitate the borrower’s exit after removing more cash than was ever put at risk. Even when the owner has been able to meet required periodic payments, he or she will be unable to retain the property when any loan comes due. Refinancing during the credit crisis will be unavailable.

Thus, the easy credit terms of a few years ago will soon begin to haunt financial institutions, many of which have been under excessive stress in the past two years.

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Jack P. Friedman, CPA, ABV, CFF, is an author, appraiser, and litigation support real estate economist in Dallas, Texas. He holds the CPA/ABV/CFF and is a state-certified appraiser, with ASA, MAI, and CRE designations. You can reach him by visiting www.realexperts.com.