Thinking about scaling your real estate portfolio into larger apartment buildings, office space, or retail properties? Once you cross into 5+ unit properties, traditional residential financing won’t cut it—you’ll need to understand the world of commercial loans. In this in-depth conversation, Stephen Morris of Advise RE sits down with Kevin Wong of Quantum Capital Partners to break down how commercial loans really work, why working with a commercial mortgage broker can save you time and money, how lenders underwrite deals (NOI, DSCR, LTV), the common challenges investors face (including bad appraisals), and how to successfully navigate the entire loan process from start to finish.
TRANSCRIPT:
Hello everyone, Stephen Morris here with Advisory and today I am super duper excited to introduce a guest to our show. His name is Kevin Wong with Quantum Capital Partners and I know a lot of you guys are very interested in commercial financing. You know once you get to apartment buildings that are greater than five units or when you start buying office buildings or retail space and all that, then going to your home lender at Bank of America, Wells Fargo, just isn’t going to cut it anymore. You’re going to have to work with a commercial bank and one of the best approaches in order to work with commercial banks is to engage a commercial debt broker. And so very excited to have you here. Thanks so much for joining and let us know just what you do and what you’re all about.
Yeah thanks Stephen for having me here today. I’m a commercial mortgage broker with Quantum Capital Partners. I specialize in financing commercial properties, apartments, retail, office, hospitality. We work with all different types of commercial lenders from banks, credit unions, life insurance companies, conduits, debt funds, private lenders. So we have a whole ecosystem of lenders available and we have relationships with all of them. So what we specialize in doing is finding the best possible commercial loan for your situation.
Yeah and to be clear we’ve worked with Kevin on salvo of our own loans. In fact every time we go into a refinance or we’re looking for construction financing, the very first person I’m going to give a call to is Kevin here to arrange the loan. So we’ll be providing his contact information at the end of this video and so please feel free to contact him. He’s going to be the best guy to help you out when you’re looking for either an acquisition loan, refinance, construction or anything in between. And so the question I have for you is what exactly do you do? Yeah you’re working with loans but what does that mean? Could you give us a little bit of an overview on what the whole process looks like? What do commercial debt brokers specifically do in the process?
Yeah good question. So a lot of people understand mortgage loans for residential properties and typically with a mortgage loan on residential property it depends on what your tax returns look like is generally what a lender is assessing your loan scenario with. On a commercial loan it’s a little bit more nuanced because every property is different. Every commercial property has different income and expense ratios and that’s really what a commercial lender is looking for. They want to figure out what the NOI on the property is, the net operating income and then from that we can determine what kind of loan program you qualify for, how much loan you can qualify for and you know what are the available options for you. So my role as a commercial mortgage broker is that I’m familiar with various types of lender programs and knowing exactly how they’re underwriting deals, how they’re sizing deals and what might be available to you in the market currently.
So the major question I have for you is I don’t know I’m a customer at Wells Fargo how come I don’t just march into the branch and just say hey I just bought a 30-minute apartment building I need a refinance can you hook me up? Why don’t I just do that? What do I need you for?
That’s a great question I mean that is one approach that you can take and Wells Fargo may or may not want to give you that loan but because I mentioned the commercial mortgage loan is so nuanced that every different property will underwrite differently. What you want to do is have a wider market approach and give you the best available loan option. So what we do is we can analyze your property, take a look at the current loan scenario and then market it to dozens if not a hundred different lenders based on the type of loan that you’re looking for and find the best possible solution for you.
When considering a commercial loan there are a lot of things that you may be looking for in getting a loan that’s ideal for your scenario. It could be getting a rate or a loan amount the proceeds and all those things need underwriting to determine you know what you’re going to get, what kind of terms you’re going to get. What we do as a mortgage broker is we package it all together, we present it to lenders, the right information that they’re looking for and get you the best possible terms by doing that.
Okay so thanks so much for that and for clarifying why we’re going to hire you versus just walking into the bank and hoping hey you know what give me the loan that I’m looking for. All right so you talked about some important concepts here. We talked about net operating income. This is a very important concept in real estate. I would argue that it is the underlying or driving force to pretty much analyzing any sort of income producing property. It’s the gold standard that we use. It’s the way that we compare two properties.
The cash flows but you also mentioned things like LTV loan to value. That’s a very important concept as well or debt service coverage ratio which arguably is not really a concept in the conventional financing world. So when you’re going out to buy a duplex yeah they’re going to consider the rental income that’s maybe off that’s generated from both units but they’re not really using a debt service coverage ratio in those scenarios. They’re using more of a global cash flow kind of concept right. They’re looking at how much the borrower makes in total. So they’re a doctor, how much income are they producing from their medical profession and also they might be looking at the duplex.
The commercial world works a little bit differently right. So they’re looking at just what you’ve mentioned here. Can you maybe break down for us what are those concepts. What’s the debt service coverage ratio. How are they underwriting it. How are they sizing the loan based on these.
Yeah that’s a good question. So I think a lot of people who don’t have familiarity with commercial loans may not fully grasp how a lender is underwriting a loan and how do they determine you know the amount of loan that a certain property qualifies for. Every property is different so what a lender has to do is look at the net operating income and calculate what’s called a debt service coverage ratio and there are three main things that a lender will look at when sizing up their loan.
One is the debt service coverage ratio. The second is loan to value and the third is actually your financials as well. So sponsors net worth and their current liquidity. So those are the three main things that a lender is looking at when they’re making an assessment of your loan. When it comes to the debt service coverage ratio what that basically means is your net operating income divided by the mortgage payment. So a typical structure or a typical debt service coverage is a 1.2 for a multifamily apartment which essentially means that your net operating income should be 120 percent of your mortgage payment.
So a lender wants to see that there’s some buffer of free cash flow after you’ve paid your payment to them and in other asset types this can be greater. So a retail property or an office property could have a 1.3 or 1.4 DCR and a hospitality loan may have up to 1.5. So in that scenario a lender wants to see your net operating income 150 percent greater than your mortgage payment.
So one thing that affects that is going to be your interest rate and the higher the interest rate is the larger your mortgage payment is and that effectively reduces your loan amount. So when a lot of people may be looking for commercial property the first time they may want to know does this property qualify for 65 percent, 75 percent loan to the purchase price. That will really depend on the income of the property and then secondary is the lender’s LTV and the LTV is loan to value.
At the most you’re generally seeing 75 percent LTV on a loan which is much lower than a residential property where you may be able to get 80 or 90 financing. On an apartment building the most you can typically leverage is about 75 percent and on other commercial property types such as retail or office that limit is lower typically 60 or 65 percent LTV. So that’s the second threshold that the lender is looking at when giving you a loan sizing.
And the third thing I mentioned is your is your financials. The rule of thumb for most lenders is that you need to have a one-to-one net worth to your loan amount. So let’s say if you’re trying to apply and qualify for a two million dollar loan a lender will want to see that you have at least two million dollars of net worth and if you don’t they generally feel like it’s risky to give you that sort of leverage and so you may not be able to qualify for two million dollar loan even if the LTV or the debt service coverage ratio is within the underwriting parameters.
So those three things generally tend to be how we size a commercial loan and whether or not a property will qualify for you know 65 or 75 percent of your purchase price or current value of the property.
Great and that’s a very important concept to have here maintaining personal financial statements, maintaining liquidity all these things are going to factor in whether or not you’re going to be able to get a loan and you might be thinking fine I’ll just stay in the conventional loan space forever and not have to deal with this. Sure if you only want to buy Korean apartment buildings or less right so if you want to start to scale up and you start to develop your real estate portfolio into different asset classes or much larger properties then guess what you’re stuck in the commercial realm. Conventional financing is going to be kind of a thing in the past maybe you’ll engage it once again when you buy your mansion Hollywood Hills or wherever you’d like it to be in the future and by the way you’ll find that to be a pain in the neck once you get the construction financing which we’ll talk about in another video so stay tuned for that.
However I’d like to talk about some challenges here maybe there’s some things that kind of go on in the loan process here which could maybe make it a little difficult to achieve the outcome you’re looking for so maybe let me ask you a few questions here. You mentioned that operating income and how there’s this relationship between NOI and the size of the loan right so if I have more NOI I can get more loan that’s generally speaking and of course the lower interest rate which I can’t really control that’s up to the bank would also drive this loan proceeds.
Why can’t I say things like well I have this apartment building and so management is zero because I do it myself so that lowers the expenses right and what if my rents are you know pretty high and I have these special arrangements with tenants to give me really really high rents how does that work out I mean can I just do those things and get a much better loan as a result of all those activities?
Yeah that’s a good question so you know lenders aren’t dumb so they know what the market is in terms of income and expenses are and they’re generally normalizing your property to the comps so if you have an exceptional property with exceptional rents they’re still looking at the general market and they may reduce that rent or gross income to where the comps are. Maybe you do a phenomenal job managing the property but if somebody else took over managing the property would they be able to perform in the same way?
So not all lenders underwrite a deal the same way. They’re going to look at your income and expenses and have deductions for expenses that you may not have. Typically there’s a repair maintenance expense that they’ll underwrite to, they’ll underwrite management and you know they may take out reserves for your property too. So on paper while you as an operator may show much higher net operating income when it goes through the funnel of a bank underwriting you’re going to have a vacancy taken out, you’re going to have some normalized expenses taken out and your net operating income is going to be on average about 70 to 75 percent of your gross income even if you may not be experiencing that in your expenses.
That seems totally unfair though because I’m killing it right now in the apartment game right I’m generating these high rents I’ve suppressed expenses I made them really low and yet you’re telling me that the lender is going to come in and actually just change my realities—is that right?
You’re saying it could happen and so some lenders may have more flexibility than other lenders and this is why when we send a deal out and we market it to a wide variety of lenders you’ll get different results, you’ll get different loan amounts coming back because every lender is sizing it slightly different and those affect your net operating income and your loan dollars at the end of the day.
So you know those are important considerations that you have to look at when observing a property that may be performing well above market and how to normalize for some of those expectations that you may get back. You may be doing your math and saying look I should be able to get five, six million dollars based on my net income but when we run it through with the normalized expenses it comes out like several hundred thousand dollars less than that.
Yeah so I’m not going to name bank names because it just doesn’t seem to make any sense but there are some banks that are like ultra conservative and believe that even if you’re doing really well and you’re making tons of money you actually aren’t. You’re actually doing really poorly in their world because they’re concerned about the risk.
And they’re very risk—all banks are risk averse so be very clear here. By the way banks are not venture capitalists. If they’re not kind of not sure about you, they’re out. They need to be 100 percent certain that their loan’s going to be paid back. Obviously there’s no such thing as 100 percent certainty but they can’t have any doubts during the process right.
I think that’s something really important that from an investor perspective, the banks are the opposite of an investor. They’re looking at what is everything that can go wrong here and so they’re underwriting to the most conservative outcome of every property. And so that’s generally the disconnect that we see with developers and investors versus what comes out on the output on the lender side is that most investors are optimistic and most lenders are the opposite of that—super, super, super pessimistic. They don’t give you the benefit of the doubt and they won’t give you the upside that hasn’t yet materialized. So everything has to be what has happened historically and that’s generally what they’re sizing it to.
But the advantage is you get a very low cost of capital as a result for them mitigating all this risk because if you want to take on someone risky guess what—they’re going to want half your property, they want your soul probably. They want all these things. A lender just wants their money back plus interest right.
Right and they’re earning some fees as well as a result of it but that’s pretty much it. Yeah so they have to be sure that it’s going to be a successful outcome. Yeah absolutely.
Okay so we’ve been through this process with you before many times but of course our audience here may not be familiar with this. Can you walk us through briefly just the loan process? I am interested in buying an apartment building, I wrote my offer and it got accepted and then I give you a call.
Okay right now what happens?
Yeah you should have gave me a call two weeks ago, that would have been better. That would have been better. So one of the things that is beneficial for anybody in the process of securing a loan is starting as early as possible.
What we see often in an acquisition scenario is you sign the purchase agreement and you have 45 days to close from that purchase agreement, but it generally takes at least a week or two to get lender feedback to get quotes back. And so there’s already a delay in your loan start time. So what you want to be able to do is as you’re identifying properties start the loan process there where you’re packaging the property information, you’re able to get some quotes generated, at least an initial review of the property, and so once you sign the PSA you have a lender ready to go and you can start the process right away.
Purchase and Sale Agreement to be clear. Yeah after you get the purchase sale agreement done and so from the time you sign a term sheet generally it takes about 45 to 60 days with the lender and in some cases you can go way faster—maybe 30 days is as quick as you might be able to go—but it’s typically not the outcome right to get done in 30 days.
So you know don’t go signing PSAs with 30 days to close and expecting a lender to come in and close within that time. More likely than not you’re going to have to ask to get an extension. You can put that in your initial purchase agreement and build in like two extensions to that and know that you’re going to utilize it.
Yeah so that’s very important. This isn’t the single-family home world anymore where you got a 30-day close and the lenders usually give you a response within seven to ten days for loan approval. They’re usually waiting on one thing which is the appraisal right.
Yeah let’s talk about appraisals because this is one area which can really throw a wrench in your process if it’s not done right. Tell me a bit about appraisals.
Yeah so appraisal is always the contingency of any quote that you get—everything is subject to appraisal. So when you sign the deal up you first start ordering appraisal and that can take a two-week process so automatically you’re already eating up 14 days just waiting for an appraisal to come back.
After the lender receives the appraisal, it goes through an appraisal review and all that could take up to three weeks worth of time. So this is why there’s generally a longer period of time for a commercial loan to close—it’s because there’s a long appraisal process.
In the appraisal they’re analyzing the property’s financials and they’re analyzing the property’s value compared to other assets, other similar assets that have sold. And so in the best case scenario your appraisal is at least equal or greater than your purchase price.
In a worst case scenario the appraisal value is below your purchase price and that means the lender is giving you an LTV based on that appraisal value so it can potentially cut your loan proceeds through the appraisal.
Another thing appraisal does is they do an underwriting as well and the lender takes the income and expenses from the appraisal and then reinserts that into their underwriting and that can adjust the debt service coverage ratio which also impacts the loan amount at the end of the day.
So those two things that result from the appraisal may or may not impact your loan amount after it’s completed. Typically you won’t know that until three weeks later so you’re pretty far along in the purchase process and you may need to have released your contingency, your finance contingency. Sometimes you’re able to extend it subject to the appraisal and if you’re able to do that, that gives you the most certainty that you’ll know what your loan amount is prior to waiving your contingencies.
Yeah so let’s talk war story here. This is before we knew Kevin by the way to be very clear, but we did go through a loan process to acquire some property in L.A. for development and somewhere in between the time we ordered it and the time it got approved by the bank the appraisal came back and it was roughly—I don’t know, call it—it was two-thirds of whatever our purchase price was.
However I knew in my DNA that the purchase price I offered was a deal—actually it was a steal to be honest with you. It was a fantastic deal. We eventually completed it but the bank cut our proceeds by about half a million bucks and so, you know, call it two weeks before closing or week before closing and they go, guess who’s got to come up with that money, right?
That was very stressful I got to tell you that much. I was eating Taco Bell for the full duration of that process. I wanted to make sure that I had enough money to at least stay afloat during it. Eventually it all worked out and we sold the project and eventually it was one of our most successful projects, but I swore to God after that I’m never going to be cooked by an appraisal again.
And of course we eventually found Kevin as a result of all this and now we don’t work with anybody but him. What are some ways to mitigate these type of challenges, how do you come across—I knew it was a bad appraisal by the way, it for sure was a bad appraisal—how do we get around that?
Yeah sometimes you get a bad appraisal and you can’t really do much about it, but what we like to do to mitigate the outcome of a bad appraisal is meet with the appraiser at the time of the inspection and also provide them with all the information they might need to justify your value.
So providing comps, providing income—the easier you make life for the appraiser, the more likely you’re going to get the results that you’re looking for. In some cases the appraiser is going to just do whatever they want to do and you can’t control that outcome but making your best efforts to provide them information that is supportive to your value will always improve the situation, you know, as best as possible.
So being prepared helps. Yeah is that the right way to say it? Yeah being prepared, having your comps, knowing what the rents are in the market, knowing how the property compares to other property in a general sense will give you a better ability to mitigate potential issues there.
Cool so I hope this really helps you guys understand what the commercial financing role is like, what it takes to start buying apartment buildings that have five units or more—that’s the magic cut off number—and if you want to start buying hotels or retail then guess what, I mean you’ve got to talk to someone like Kevin here.
So if you’re interested in learning more, if you’d like to understand a little bit more about the process then we have our contact information right here and you can contact Kevin if you’d like to talk about any loans.
And if you want to talk about the tax side of things and how those will impact you in the future then of course our contact information is right here and we look forward to seeing you in our next video. Thanks so much for joining.
