Anatomy of a loan

A recent Virginian-Pilot story about the high vacancy rate in commercial properties really hit home. I used to make loans on commercial properties, so I cringe when I see one under stress, or worse, foreclosure. Some of those loans are likely to be ones I approved or asked others to approve.

How did they get into trouble so fast? Stick with me while a walk you through a fictional case history in Dare County. It’s not hard to see how problems multiply when the real estate market goes bad.

Plans for a small office building

A developer and his backers decide to put up a 10,000-square-foot office building in 2005. He finds a parcel on U.S. 158 for $800,000. Construction will cost $125 a square foot, so the total price is now $2,050,000. The developer gets half of the property under pre-leases before he visits the bank for a loan. His appraiser confirms the pre-leases and figures the building could be leased out at $25 a square foot and be full 12 months after the project’s done.

The bank is happy. Possible tenants look reputable. The developer is otherwise financially sound and could pay out of pocket if rents should falter for a while.

So we have a $2,050,000 project and $250,000 in gross rents – 10,000 square feet at $25 a square foot. The developer puts 20 percent down, leaving a loan of $1,640,000. A bank during the boom would loan at 7 percent or so, and community banks would usually amortize the payments over 20 years. This leaves payments of $154,000 per year agains rental income of $250,000. There will be management fees, taxes, insurance, perhaps some vacancies. Most banks would reduce gross rents by at least 20 percent, leaving $200,000 in “net operating income”.

The loan looks good, for now

The bank is looking at $200,000 in rental income against $154,000 in payments, for what is called an after expense coverage ratio of 1.3 (200,000 divided by 154,000). Most banks want coverage to exceed 1.25, so this loan meets that minimum. To be extra careful, the bank would also average in the personal income of the developer’s backers. Let’s say there are three – a physician, a Realtor and a retired lawyer with solid dividend income. Their post-personal debt income increases the coverage ratio even more to the bank’s liking, say 1.6.

The building is completed, and it leases up as predicted. A law firm, a real estate sales company and an engineering firm take up 5,000 square feet. The rest is leased by a small insurance agency, an architect, an office for a landscaper and a title insurance company.

Then the real estate market crashes

Three years later, we’re in a real estate crash. Even though the bank was happy at first, our one-dimensional economy creates a major problem. Every tenant is tied to the real estate market. The attorney closes loans, the real estate company sells the houses, the engineer lays out the subdivisions and makes sure houses comply with building codes, the architect designs the buildings, the insurer writes the property insurance, the title company insures the attorney’s work and the landscaper sods the yards. The developer is hurting, and among his backers, the Realtor’s income is down by two-thirds and the retiree’s dividend income was destroyed in the stock market crash. Only the physician is left standing, unable to shore up the project on his own.

By 2008, many of these tenants are gone, or if surviving, are doing so with annual revenue down 30 to 70 percent. This pattern is repeated all over the county, and soon vacant offices are everywhere.

In our fictional building, rents have now declined to $18 a square foot. The $250,000 in gross rent is reduced to $180,000, if the owner can lease the entire building. After 20 percent expenses, net revenues are $144,000. But the annual debt payments are still $154,000. Even fully leased, the investors are $10,000 short in their ability to repay. If the building is only 75 percent leased, that’s netting $108,000 against $154,000 in payments. Uh-oh.

Now the bank has a $2 million bad loan, even though our building originally was entirely leased and appraised at cost or slightly more, and the owner put in 20 percent ($400,000) of his own cash.

What is the bank to do? Suppose it forecloses? What is the value of the building?

Picking up the pieces

An appraiser will look at the rents in the current market and the vacancies. If the building is 25 percent vacant at $18 square foot, the appraiser is likely to settle on $15 a square foot as a truer reflection of the income potential. He will then take the $150,000 in projected rents and reduce them to a net income of $120,000.

Next, he will compare this with alternative investments and come up with what’s called a capitalization (or “cap”) rate. Let’s say T-bills represent a safe investment at 3.5 percent and junk bonds return 11 percent. The appraiser determines the new tenants will be composed of mostly small “mom and pop” businesses. He picks a cap rate closer to junk bonds than T-bills, say 9 percent.

Next, the appraiser takes the net rents and divides them by the cap rate: $120,000/.09=$1,333,3333

The same building that appraised at over $2 million in 2005 is now worth $1.3 million. If the bank still owed close to $2 million, its loan to value is now over 150 percent, and if it wants to sell the building, it will take a write down of $700,000.

Now consider all the banks in the area and all the empty buildings and projects. The local total is potentially staggering. Consider that some of the banks are statewide or and even national, and the problem multiplies quickly.

Just to make you sleep even less soundly, given the rate shopping malls are failing nationally, especially in mid-sized cities – you might not want to know that insurance companies are often the primary lenders in this sector. Better not count on that cash value, annuity or even the death benefit . . .