Make sure clients have an exit strategy from income property

Fred Hollister, senior vice president, director of commercial lending Global Fundings Inc.

As published in Scotsman Guide's Commercial Edition, July 2012.

Commercial mortgage brokers and loan originators focus on helping clients purchase and refinance income property. An often-neglected, yet important, part of their role as advisers should be to help clients craft an exit strategy from those properties, as well.

Over the past few years, lenders have placed more and more emphasis on how applicants plan to pay off their loans. This is a change from the time when lenders simply presumed borrowers would either sell the subject property or refinance the loan when it matured. Write-ups for loan-approval committees frequently detailed that plan as the only exit strategy.

This change in the lending environment has created a specific area where commercial mortgage brokers can add value to their transactions. If your client hasn’t already thoroughly planned how to move on from an investment, or at least how to pay back the remaining principal when the loan comes due (or adjusts from a fixed-rate product to an adjustable interest rate), you certainly can assist in putting this together.

Be prepared, however, to have a tough time convincing a client who is trying to purchase a commercial real estate investment property that getting out of it can be considerably more difficult than getting into it. Here are a few points to keep in mind when helping clients craft an exit strategy.

Understand your client

Good brokers know what the client wants to do — purchase or refinance a property. Great brokers know why. To do so, uncover the following about your client’s plans:

• Desired term of investment;
• Primary goal — market appreciation or positive cash flow;
• Other investments — child’s college education money or retirement funds;
• Risk tolerance;
• Planned property management;
• Timeline; and
• Potential buyers.

Based on your findings, determine in which scenario your client’s deal fits best. From there, you can see what the best financing and exit strategies are for the property.

1. If your client plans to hold the property for less than five years, the exit strategy is to flip it — sell it at a profit and move on. A fixed-rate loan with a long prepayment period probably is not a good choice in this case. A prepayment penalty that is longer than the fixed-rate period of the loan can limit your client’s future choices. A few commercial loans renew the prepayment provision when the fixed-rate period has burned off to make it adjustable. Think long and hard before putting your client into such a loan program.
2. If your client plans to own the property for five years to 10 years, the most probable exit strategy for the purchase loan is a refinance. Your client will keep the property, but not the original loan. In this case, a five-year fixed-rate loan with a declining prepayment penalty likely will work. Often the investor will want to take some cash out after five years. This exit strategy would be based on the property’s operating results, realistic projections of income and expense, and the tenants at the time of refinance.
3. If your client intends to own the property for more than 10 years, the most probable exit strategy is an initial refinance followed by a sale via a 1031 Exchange. Until the market’s recent steep decline, many investors found they couldn’t purchase a new property that offered better returns than the one they already owned.
4. If your client owns a retail property, make sure the lease contracts require tenants to submit annual financial statements to the landlord. Most lenders today require financial information from all tenants occupying a space of 20 percent to 25 percent, or more, of the overall property. This is particularly important if your client wants to refinance the property.
5. An individual seeking a property from which to operate a small business will probably hold it until retirement and then sell the business. The long-term exit strategy would be to lease the property to the new owner.

The bottom line is to build flexibility into your client’s deal, and do your best to keep future options open and not just dictated by the market. For example, a loan that has a fixed interest rate for five years and then adjusts provides more options than a loan with a five-year term. Long-term ownership of income property tends to work best. Your client can afford to over-improve it if the debt is low enough and the ownership time frame is long enough.

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