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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2012

Where’s the Door?

Make sure clients have an exit strategy from income property

Where’s the Door?

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.

Loan term

The maturity of the loan is an important part of the exit strategy. This is especially true if your client has multiple income-property loans. If all the loans were from the same lender and that lender went out of business altogether, your client would have to refinance all the loans at the same time.

Clearly, juggling multiple refinances at once is not the best exit strategy. A better approach that a commercial mortgage broker should consider is to “ladder” the maturities. This keeps the borrower from being subject to a market downswing that coincides with the necessity to refinance.

Keep it simple

How the client got in can have an impact on how easy your client can get out. An overly ornate, complicated purchase transaction can tie the property up in a manner that makes the exit sticky, time-consuming  and expensive.

If it takes a full page to explain the purchase, most lenders’ eyes will glaze when you pitch the refinance transaction. This is especially true if you are working on a Small Business Administration (SBA) refinance loan. That is why commercial mortgage brokers must be aware that if they structure a complex purchase, they should be sure to build in a straightforward exit strategy.

Don’t make the purchase too simple, however. Occasionally a client will purchase a commercial property for cash and no debt — planning to later get a loan and take at least some of that cash out of the deal.

Many lenders today are not enthusiastic about this transaction. They are concerned about an applicant getting this much cash at one time. It is understandable that some brokers may question such old-school underwriting, but you may not be able to talk a lender into it if that is its view.

What you can do — if your client provides you the opportunity — is research the transaction in advance and have a target lender ready to review the deal once the purchase closes. The opportunity to purchase that property may have a short fuse, and your client may buy it for cash because there isn’t time to arrange for a purchase loan.

With your knowledge as a commercial mortgage broker, you can add value in this situation by having a primary lender and a back-up lender that likely will listen to the story and consider the loan — despite the fact that it is largely cash-out. 

The sixth ‘C’ of credit

Commercial mortgage brokers are familiar with the five C’s of credit — cash, character, collateral, conditions and credit. Cash includes the purchase downpayment or cash equity still in the property for a refinance, liquid assets, and the property’s cash flow — this last item may be covered under collateral, as well. Character perhaps is the most important aspect, and the hardest to define. A borrower willing to repay is much more valuable to a lender than someone who owes the money and can repay but just doesn’t. Collateral includes the subject property, its current condition, the local market, etc. Conditions are the loan terms. And credit is the applicant’s proven history of paying debts on time.

The sixth C is customer. When the market went sideways and lenders could be — or, as was often the case, had to be — selective about prospective borrowers, applicants with an established successful history at that institution were first in line for a new loan. This doesn’t always work out for the mortgage broker because the lender often will refinance that applicant or offer the borrower new loans without using the services of the original broker.

You can — at least to some extent — limit that from happening by:

  1. Demonstrating you’ve added value to the deal; and
  2. Staying in touch with your client.

It still may take place, of course. You must understand how the lender will deal with a borrower before you bring the applicant to it. The more banking relationships the lender requires, the higher the chances they will subsume your client. 

Factor in property type 

The property type certainly can influence the disposition strategy. If there is a dramatic change in the profile of available tenants, or in the overall local market, the property type can make a big difference. An apartment building, for example, probably always will be an apartment building. A multifamily property might be repositioned to target a different tenant population, however, via rehabilitation and renovation.

Some property types may not be readily repositioned for a different use. The classic extreme cases are bowling alleys and movie theaters, which might become churches or other meeting halls, and that’s just about it. This is what makes single-purpose buildings often difficult to finance — based on how difficult they are to reposition.

Examples of property that easily can be repositioned include school properties that can become day care centers — or vice versa. Small office properties might become schools, as well. 

Because a typical exit strategy does not include a significant expenditure to reposition the property for re-use, that likely won’t encourage many lenders. It is an important issue for you to keep in mind, however — again, depending on the property type. The option to reposition the property can serve your client as a fall-back position — a plan B.

• • •

Commercial mortgage brokers can better serve their clients by working with them to carefully plan an exit strategy that suits their investment needs and the characteristics of the property itself. Be sure to include an appropriate exit strategy along with other loan- request documents. By doing so, you will be providing a genuine service to your clients — plus you will increase the odds the loan will be funded and your deal will close successfully..


 


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