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Commercial Property Valuation

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Beauty is in the Eye of the Beholder

Margaret Hungerford, Irish Author

Commercial real estate investors, like homeowners, are optimists by nature. They always expect their property to be worth more, and they always expect the market to go up.

Not so with commercial lenders. All lenders are pessimists. They think the economy is going to crash any moment, and all of their borrowers are going to run out of money, forcing them to foreclose and end up with a lot of real estate worth considerably less than they thought.

Borrowers beware! When you enter the world of commercial real estate lenders, you have to take on their mindset. Be prepared for the worst and show them how you can still make the deal work when things go awry.

Buying at a “discount”

Here’s a case in point. Commonly, investors look for deals. They try to buy property “under market.” The mistake comes in thinking that the lender will lend against that phantom “market value.” They won’t!  What’s really going on here is the investor is making a great buy based on upside potential. But lenders don’t lend on potential, they lend on actual value. The actual value today (or any day) is what someone is willing to pay. If a borrower has a property tied up at $10 million, even though it may be “worth” $40 million in upside potential, today, that property is worth $10 million. This is the number lenders will “allow,” subject to an appraisal confirming its value “as is, where is.” So, the lender will offer funding for part of the purchase price, maybe as low as 50%, maybe as high as 80%, depending on the particular circumstances of the property, borrower, location, market, etc.

Bridge Financing

Now read the fine print. If a property is being purchased as an under-performing property, and therefore the investor is getting a great deal, then this property is not eligible for conventional financing. The lender is going to offer what’s called bridge financing, or even hard money.

Why? And what’s the advantage to the borrower? Well, think about it—bridge money comes with a higher price tag, a shorter term, and usually little or no pre-payment penalty. Its function is to bridge the gap between where the performance of the property is today and its upside potential.  Borrowers should not be afraid of the higher interest rate. They should be very focused on getting the property up to the performance standard they have in mind, and getting out of that bridge loan as soon as possible, with no penalty!

Now, when the property has been renovated, landscaped, upgraded, rents raised and fully occupied, the property will qualify for conventional commercial financing at the now higher value.

Construction Financing

Here’s another scenario I’ve run into a number of times. With the fluctuations in material and labor pricing and economic uncertainty in most sectors, this is especially relevant.

Construction lending has its own special nuances. Reality is, on day one, when the borrower and lender close on the loan, with the understanding that the property will be developed to an agreed-upon specification, the “collateral” is a bunch of dirt!

A fairly typical scenario in commercial construction (including residential subdivisions) is that the property is divided into lots, or will be subdivided after development, and the units will be sold off individually, either as is, or after construction. The challenge the lender has is what happens if the project fails before the completion of development and/or construction? Then the lender is left with a partially completed project that they must liquidate in order to recover their principal. Will the lender follow the developer’s game plan and sell off those lots one at a time? No! The lender’s interest is in liquidating as soon as possible with a bulk sale. Will the bulk sale “value” ever equal the sum of the total of the individual lots? Not in this lifetime!

Make the Loan Request Real

So what number is the lender going to use as the current “market value” of the undeveloped property or unconstructed project, in order to determine the loan amount? Good question! The answer, to some extent, is going to depend on the lender, the project, the location, and even the borrower. The lender will use all of these factors to gauge their perception of risk and determine both the final value they are willing to lend against, and the loan-to-value they are comfortable with.

COVID-19 Update: Given the current market uncertainties, lenders are categorically reducing the value of certain types of property, e.g. hospitality. If you want to know the latest and find out how you can get financing to acquire a new property or refinance one you already own, CONTACT US now!