The .2 rule vs actual value

[RoryMillerJr]

I understand how to use the .2 rule to figure out what to offer on a commercial property. How though after determining that do you determine what the actual value will be so you know what % ltv or of the estimated price off you are getting the property. Do you have any formulas for that or is it something done by just comping similiar properties in the neighborhood?

[propertymanager]

I believe that you should become an expert in your local market.  Therefore, I am a big proponent of looking at 100 or more properties (inside and our) that are for sale in your local area.  Keep looking until you can look at a property and KNOW the market value. 

Just to be clear, the 2% rule is for residential rentals and isn't appropriate for office space, retail, etc.

Good Luck,

Mike
   

[jbaldwin]

LTV is simply a bank calculation.  Commercian banks will go to 80% LTV on whichever is lower, the purchase price or the appraisal.  Certainly you need to know this but I wouldn't use any sort of LTV number when determining my offer.

Propertymanager will disagree with this a million times over but the way to determine if you are getting a deal on the property is to compare the cap rate of the property you're buying with others that have sold in the area.  The cap rate will tell you if you're getting a good deal on the value of the building.  Especially if you're dealing with commercial properties.

Propertymanager - is there a rule that you are aware of for commercial properties, and by that I mean office, retail, industrial.  Not residential properties that are financed w/ commerial bankers?

[RoryMillerJr]

So propertymanager what is your method for coming up with an offering price on an apartment building?

[propertymanager]

I must have $100 per unit per month positive cash flow USING REAL WORLD CASH FLOW.  Therefore, I will pay only what will generate that cash flow with 100% financing.

Commercian banks will go to 80% LTV on whichever is lower, the purchase price or the appraisal.

I don't agree with this statement.  I am currently just about to close on 4 buildings/11 units with financing for 100% of the purchase price.  I have a friend that also recently bought a property and got more than 100% of the purchase price to provide for rehab money.  Of course, both of these loans were at a low LTV.  So, what I'm saying is that some small local banks will go 100% of the purchase price if the LTV is low.

The cap rate will tell you if you're getting a good deal on the value of the building.  Especially if you're dealing with commercial properties.

In a perfect world, the cap rate would give you the market value of a property.  As we've discussed ad naseum, there is no accurate real world expense data the vast majority of small residential rentals.  Realtors, investors, and others just make it up.  Therefore, the market cap rate for msall residential properties is meaningless.  Moreover, since most residential units are owned by individuals and most newbies fail, all any cap rate for small residential rentals is really telling you is what the losers paid for their property.

Propertymanager - is there a rule that you are aware of for commercial properties, and by that I mean office, retail, industrial.  Not residential properties that are financed w/ commerial bankers?

I am not aware of one, but FDJake would be a better person to ask.  I am not significantly involved in non-residential commercial properties.

Mike

[Dave T]

Rory,

If you are looking at purchasing a commercial property, then you can't really determine how much to offer until you know how much financing you will need. 

The first step in the process is to figure out the net operating income that the property will generate.  Hopefully the seller will give you his last two years income and expense reports so you can see what the income was and the actual expenses the seller incurred.  At the very least, the seller should prepare a pro forma income statement showing you the potential income for the property at 100% occupancy with the projected annual expenses for the coming year.  Check the seller's numbers to make sure they are realistic and use your own numbers if you are coming up with higher expense estimates and lower gross income.

Using the seller's numbers, figure out what the net operating income would be assuming the property is owned free and clear.  Once you know what the net operating income is, divide the NOI by 1.3 to determine the maximum debt service the commercial lender will allow for this property.

With the annual debt service number (principal and interest) you can figure out what the maximum loan amount is that you can get for this property.  Since the lender will want you to put at least 20% down, divide the maximum loan amount by 80% to determine the most you can afford to pay for the property and still get financing.

Now that you have calculated a maximum offer price, is that price higher or lower than the seller is asking?  If higher, then you may want to investigate further to see why the property is priced lower.  Is there deferred maintenance, a high vacancy rate, the seller in bankruptcy or going through a messy divorce?  Are there problems with the property you can easily solve?

The next step is to divide the NOI by your maximum offer price to determine your capitalization rate (cap rate).  Effectively, the cap rate tells you the rate of return on your investment at your price.  If this rate of return is not acceptable then you have to lower your maximum offer price to get the cap rate (yield) you need to have.

If the asking price is higher than your maximum offer price, and you cannot negotiate a lower price, then you will need a larger than 20% downpayment at the settlement table if you proceed with the purchase.  Because you have already figured out the maximum amount the lender will loan on this property, you know that the lender will not give you 80% financing on a higher purchase price.

The cap rate calculations can tell you whether the seller's asking price is in line with other comparable properties in your area, but there is no point in establishing your offering price based upon the "prevailing standard" cap rate if you can't afford the financing.

I suggest you determine the maximum offer price you can afford to finance; then, if the cap rate is less than you need, lower your offer price accordingly tto raise the cap rate.

As an afterthought, I have never heard of a ".2 rule" related to commercial property.  Not really sure there is one for 1 - 4 family residential property.  You will have to tell us what you mean by the ".2 rule" so we really know where you are coming from with your question.

As far my experience goes, commercial lenders have two rules,

• The loan can not exceed 80% of the purchase price (or appraised value whichever is less), and,
• The NOI can not be less than 130% of the debt service.

If you have a track record with investment property, high liquid assets, other sources of income and an established banking relationship with the lender, the lender may lower the debt service coverage ratio to something closer to 120%.

[jbaldwin]

Or you could make it this simple.  Figure out what you want your purchase price to be based on cash flow projections and then figure out what that that financing is going to cost you.  Take your NOI, divide by the debt service and that will give you your DSCR, which should be 1.2 or above.  At 1.2 that bank will finance the deal usually.  The higher this number the better deal you have made for yourself.  An easy way to remember it is "Net divided by Debt" and as long as you're >1.2 you're good as far as getting financing.

"With the annual debt service number (principal and interest) you can figure out what the maximum loan amount is that you can get for this property.  Since the lender will want you to put at least 20% down, divide the maximum loan amount by 80% to determine the most you can afford to pay for the property and still get financing."

I have to disagree with this statement in two places.  1)  You don't have to put 20% down.  I have never put down 20%.  I have either cross collateralized a property or had the seller hold a 20% note.  2)  That 80% number is not the most you can afford to pay for the property because the property may be 100% financed, or maybe 90%, etc. and you have to calculate that into your offer accordingly.

[RoryMillerJr]

Thanks guys for all your responses. Sorry if I confused you with the .2 rule. I got that confused with the 1-4 units. I am all over this site trying to take in as much information as I can. This site by far has been the best place for me to get information and I appreciate all you seasoned vets and even newbies taking the time to get me on the right track. Property manager what software was that again that you use and where can I pick that up at?

[Dave T]

I have to disagree with this statement in two places.  1)  You don't have to put 20% down.  I have never put down 20%.  I have either cross collateralized a property or had the seller hold a 20% note.  2)  That 80% number is not the most you can afford to pay for the property because the property may be 100% financed, or maybe 90%, etc. and you have to calculate that into your offer accordingly.

I was only relating my experience with institutional commercial lenders.

I have never had a commercial lender allow the seller to carry back more than 5%.  

I have never had a commercial lender agree to finance more than 80% of the PURCHASE price with a primary mortgage loan.    

According to Rory's posts, he is a first time investor with no other investment property.  Cross-collateralization is not an option for him. 

I agree with you that a 20% downpayment and 80% financing is not necessarily the most you can afford to pay for a property.  I should have worded that differently.  What I intended here is with the maximum 80% lender financing, determine the maximum loan amount possible.  Since the lender will require  Rory to bring a 20% downpayment to the table, then my calculation is determining the highest purchase price Rory can offer to pay for the property and still use 80% financing from his commercial lender,  I did not mean to suggest that Rory could not afford a larger downpayment and pay even more for the property.

Rory is really looking for a 0 down deal.  With no property to cross-collateralize, chances are he is not going to get a 0 down financing arrangement on a commercial property especially with no track record.  He may have to bring in cash partners to supply the downpayment.

[jbaldwin]

I have never had a commercial lender allow the seller to carry back more than 5%.  

Wow, my commercial guys always suggest a seller carry back when I propose a deal to them.  You get up to $1 million and that means you have to come to the table w/ $200k, that's though!  You may want to consider working with other lenders.  Imagine how many deals you're missing out on if you could do a 20% second.  Unless of course you've got the cash, then this is a moot point.

I have never had a commercial lender agree to finance more than 80% of the PURCHASE price with a primary mortgage loan.  

I agree.  I try to use local banks for as much as possible and generally speaking those are 80%, 1.2 DSCR banks.  I know mortgage brokers can get 90% if you want to pay 9%, but you know.... 

[propertymanager]

I've got to tell you that I don't know what you guys are talking about.  It's like we're living in two completely different worlds.  I have bought the majority of my rentals with the bank loaning 100% of the purchase price, but with a low LTV (always under 70%).  I'm closing tomorrow on 4 buildings/11 units with a commercial loan and they are loaning 100%.  I have a friend who just bought a large house for a rental and she borrowed the purchase price plus the rehab money.  This was from a different bank.  These are all being loaned to LLCs and are all commercial loans.

Mike

[Dave T]

OK guys.  If you say it can be done, then obviously I am talking to the wrong lenders.  There is this $8 million apartment complex in OK that I might want to buy, but the 20% down hurdle has been too high for me to jump.

[LIGHTBEING]

Guys, please understand that there are a variety of programs out there for each and every situation. 

Each lender has it's "niche"

I see alot of smaller lenders offering 75-80% financing based on ARV.  In most cases this will work out to be 100% of the purchase price.   It's really understanding how they underwrite the deal and the programs they offer.

Now once you get into the bigger acquisitions those programs begin to disappear.  Unless you have built a reputation with a lender you won't find that many 100% financed deals.  Rehab loans are out there, but unless you are an experienced rehabber on bigger buildings, don't expect them to hand over 100% LTV/LTC.

You could even cross-colateralize your other property to obtain 100% financing.  The list is endless when you have the resources.

And then there is ofcourse the non-traditional way of getting the property ultimately 100% financed by using OPM.

Typically, in the commercial world, a plain vanilla loan is 80% LTV/LTC.  Some of these Conduit/CMBS lender could attach a Mezz peice onto the loan to get you up to 85% with a blended rate.  But don't expect much more.

I've seen some HUD loans $2M+ around 85% LTV that allow a 5% seller second.  However the HUD loan process isn't that attractive.

I hear alot of people inquiring about 100% financing because you hear all these "guru's advocating it.  I was guilty of the same thing when I first started.  They make it sound so easy, even in the commercial world.  Please be realistic.  A bank is not going to hand over 100% financing to even a novice investor. 

If you are new trying to get your foot in the door, maybe you will have better opportunities starting small, maybe a SFH or a duplex.  These would qualify for some very attractive LTV's.

Stop focusing your time and energy on 100% commercial loans and start redirected your efforts on something else.

[Sean_L]

I worked for a few lenders in my day. Both mortgage bankers and mortgage brokers and I also sold mortgages to the former. I have never seen a bank that will lend 100% based on purchase price. The gentleman that said it is based on purchase price or appraised value which ever is lower is how I have always seen it. If you bother to go read the Appraisal Institutes definition of market value you will understand why it is so. I personally think propertymangers loans are pie in the sky. Lets play name that lender..

[propertymanager]

I personally think propertymangers loans are pie in the sky. Lets play name that lender..

Well, you can think what you want.  As I've said many times before, you need to use small local banks that keep their loans in their portfolios.   

I certainly will not name any of my local banks.  The very last thing they want is a bunch of newbies with no money and bad credit from the internet calling them for loans.  That would be a great way to make the bank very unhappy with me.

If you think that you can't do it, you're probably right.

Good Luck,

Mike