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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2016

Distressed Properties Differ from Distressed Neighborhoods

Target lenders that fund transactions addressing the needs of both

Distressed Properties Differ from Distressed NeighborhoodsA distressed property differs from a distressed neighborhood. Commercial mortgage brokers need to understand the distinctions so they can select the right lender for a transaction.

Distressed properties are neglected buildings. They are isolated instances of property deterioration caused by an owner’s lack of ability or interest in upkeep. Distressed neighborhoods are usually the result of economic factors beyond any single property owner’s control.

Commercial lenders understand this distinction, and many possess the skills to lend in both niches. Their referral sources — mortgage brokers — must be prepared to address the questions and challenges raised in either scenario in order to secure loans for their clients.

Lenders’ obligations

It is important for mortgage brokers to understand their lenders’ appetites for doing business in the more challenging areas they serve. Those commercial lenders, whether they are banks or nonbank lenders, have an obligation to lend in their communities and help turn around distressed neighborhoods. Banks, in fact, are required to do so under provisions of the federal Community Reinvestment Act (CRA).

Lenders operate under the belief that helping small businesses thrive in a neighborhood is the first step in reviving a community, and they see their work in distressed areas as a legitimate responsibility. The fact that lenders are active in distressed areas, however, does not mean they are abandoning smart underwriting.

In distressed areas, lenders evaluate transactions by examining the traditional financial markers — including credit strength, borrower capacity and collateral value. In addition, add the concept of “fit” — which raises questions such as the following:

  • Does the area need this property use?
  • Is there demand for this property use?
  • Will the property occupant satisfy a community need?

Making your case

When a project addresses demand in a challenged neighborhood, it has a high probability of success. Referral sources need to focus on this. They need to present their lenders with the facts about why the proposed venture will succeed. They need to explain why a lender should take on the risk and how this risk is mitigated by the strengths of this specific deal.

Successful mortgage brokers also need to know which lenders will finance distressed properties. They need to have a group of lending sources composed of banks and nonbanks offering long-term financing, hard money lenders and fix-and-flip lenders — which all have programs designed to allow a borrower to turn a distressed property into a solid asset.

The important thing for a broker to remember when pursuing this type of transaction is that the loan must move the property toward a desired end. This means the borrower must have a plan that is well-developed and results with the property no longer being distressed. The mortgage broker needs to assist the borrower in presenting to the lender the details of how the requested loan will result in the sale, occupancy or refinancing of the property.

Judging value

Early in the process, mortgage brokers should understand how their funding source looks at property value. Many lenders look at appraised value as well as improvements and their cost when funding permanent loans on recently acquired properties. By understanding how each lender looks at the issue of property value and what that lender’s seasoning requirements are, brokers can provide a tremendous service to their clients.

For fix-and-flip or fix-and-occupy properties, the broker needs to make sure that the borrower has estimates for all work being done by third parties. If the borrowers are doing some or all of the work themselves, the loan package needs to include a description of their skills and past projects.

When you fund the rehab of a distressed property with a lender that offers short-term funding, you create the opportunity and the need for a second transaction.

If the borrower is going to keep the property and occupy it, then the loan-submission package should include information about where the business is moving from, the amount of space it currently occupies and what cost savings or increases will result from this move. If the property will be tenant-occupied, then the loan package should include a pro forma profit-and-loss statement. The more information the broker provides the lender, the quicker the response will be and the sooner the borrower can begin work on the project.

Also, it is essential for brokers to understand the regulatory restrictions that can make brokering certain types of loans on distressed properties a little more difficult, especially issues of licensing related to one- to four-unit properties. Some states require licenses for brokers who place loans on mixed-use properties that contain residential units, and others require licenses for commercial-property transactions.

The best way to minimize or avoid licensing requirements is to make sure your clients are conducting their transactions under a corporate name. With very few exceptions, loans made to “non-natural persons,” such as corporations or limited liability companies, are exempt from licensing requirements. Structuring your client’s loan under a corporate umbrella, even when the company principal needs to provide a personal guarantee, should allow you to transact business in almost any jurisdiction and with access to a large variety of funding sources.

Loan-term considerations

Brokers who pursue loans for distressed properties also have to consider the time frame of the financing. Can a long-term loan be arranged for the transaction, or is a short-term loan better — or the only option for this particular deal?

If you can find a long-term lender, be aware that the structure may require an escrow for repairs. In that case, there will be money held at closing to ensure the work is completed. That can be a complication. On the positive side, however, your customer will be able to remain in the transaction after the rehab work is completed on the property and not have to seek refinancing. In the case of a short-term loan, the client will eventually need a take out another loan to refinance the deal.

When you fund the rehab of a distressed property with a lender that offers short-term funding, you create the opportunity and the need for a second transaction. When the work on the property is completed, your borrowers will need you to help them find the long-term mortgage necessary for them to retain ownership. This gives the mortgage broker the chance to place a second loan for the customer, and that becomes an opportunity to earn a second fee.

• • •

Lending on distressed properties allows brokers to earn income in a variety of ways by being of service to their clients. The key to success is having a variety of lenders and knowing what each lender’s appetite is for loans on distressed property and for loans in distressed locations.

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