Guidance for Utilizing Sections 121 & 1031 in Combination

Virtually all CPAs, tax attorneys and other tax professionals will bring the Principal Residence Exclusion under Section 121 of the IRC to the attention of their clients at some point in their careers. Likewise, there is an equal probability that tax professionals will suggest that at least one of their clients conduct a tax-deferred exchange under Section 1031.

Both of these sections are among the most financially beneficial provisions of the tax code. Just by themselves, each of these sections has the potential to save taxpayers hundreds of thousands – and even millions, if Section 121 be used repeatedly – of dollars in taxes.

Section 121 refers specifically to personal residences, while Section 1031 refers to real property held for investment or business purposes. Previously, Section 1031 could be applied to personal property held for business or investment, but this application was recently removed with the Tax Cuts & Jobs Act. While these sections are undoubtedly powerful when used separately, when used together in combination they can be even more useful for taxpayers.

Converting Property Before the Sale

Section 121 allows individual taxpayers to eliminate up to $250,000, and married taxpayers (filing jointly) to eliminate up to $500,000, of gain from the sale of a “principal residence” (or “primary residence”). To qualify as a principal residence, taxpayers must own and reside in the property for at least 2 years out of the most recent 5-year period. These 2 years do not have to run consecutively, and so it’s possible for a taxpayer to reside in a property for 1 year, live elsewhere for 3 years, go back and reside in the property for another year and then sell the property using the benefits of Section 121.

If you want to combine these sections prior to the sale, you will have to establish the property as your personal residence and then convert the property into an investment vehicle. This means that you will need to satisfy the time requirement of Section 121 and the holding requirement of Section 1031.

Section 1031 is only eligible for real property “held for” productive use in trade or business or for investment. Unlike with Section 121, this holding requirement is not strictly a time requirement, but is based on the intent of the taxpayer, and intent is established by considering all relevant facts and circumstances surrounding the taxpayer’s ownership of the property.

Here’s how a transaction involving both 121 and 1031 before the sale might proceed:

you acquire a property, move in and reside for 2 years, and then exits and converts the property into a rental

you then hold the property for investment for 18 months, being very careful to treat it just as you would treat any other piece of investment property

you sell the rental property and are able to utilize the exclusion provided by Section 121 and also the tax deferral benefits provided by Section 1031

Utilizing 121 & 1031 in an Allocation

Sections 121 and 1031 may also be combined in cases involving partial personal use of an investment property. You may currently reside in only a portion of your investment property. For instance, you may own a multi-unit rental complex – say a complex with 4 units – and resides in 1 of the units and rents out the remaining 3 to unrelated renters. In this scenario, you would be able to utilize both sections, just as in the example given above, but you would need to “allocate” the portion used as a personal residence when conducting a 1031 exchange.

Suppose that your 4-unit complex has a sales price of $1 million. In this case, the taxpayer would allocate the personal residence portion and invoke Section 121 to eliminate the gain associated with that portion rather than the entire complex. In other words, only the gain realized from the personal residence portion would be eligible for exclusion under Section 121, whereas the remaining proceeds from the other 3 units would need to go toward replacement property under Section 1031.

Converting Property After the Sale

The rules for using these sections in combination after the completion of a Section 1031 exchange are a bit more involved and so you will need counsel. After completing an exchange, taxpayers may convert their replacement property into a personal residence and then take advantage of Section 121 to eliminate some (or all, depending on the situation) of the gain.

However, in this scenario, taxpayers must own the replacement property for a minimum of 5 years following the exchange transaction; this is true even though taxpayers still only need to use the property as a personal residence for 2 years to satisfy the use requirement of Section 121. After owning the property for at least 5 years, and using it for at least 2 years during this time period, taxpayers may sell the property used in the exchange and utilize Section 121.

But, in the case of a post-exchange conversion, the time that the taxpayer uses the property as a personal residence figures what amount of the gain is eligible for exclusion. The rule works like this: the amount of time during which the property is used for investment purposes is considered “non-qualifying use” for Section 121, and so that amount of time cannot be used toward the exclusion; taxpayers will put the amount of non-qualifying use in a fraction as the numerator, and the total number of years that the property is owned will be put as the denominator.

The fraction which shows up represents the portion of the realized gain which is not excludable under Section 121. Here’s an example:

you finish a like-kind exchange and then own the property for a total of 8 years after the transaction

you rent out the property for just 2 years following the exchange, and then move in and establish the property as your personal residence for the next 6 years.

You then decide to sell the property and wants to use Section 121.

In this scenario, 2/8 of the gain (or ¼) would be considered not excludable under the principal residence exclusion because that would represent the non-qualifying use period during which the property was used for investment.

It’s important to remember that the holding requirement still applies on this post-sale side of the transaction, and so practitioners should be sure to counsel their clients about the risks associated with converting their property into a personal residence prematurely. If taxpayers do not satisfy the holding requirement on the post-sale side, they run the risk of having the underlying 1031 exchange transaction nullified by the IRS.

 

Using Social Media to Market Your Rental Homes

There is a big difference between a rental real estate mogul and someone who manages a handful of properties they rent to local residents — especially when it comes to marketing. Real estate corporations and investors with dozens of homes in their portfolios are marketing all the time. They have invested in fancy websites and constant social media campaigns because there is always another unit to fill and another tenant moving out in the near future. For local landlords and property managers, however, you could go months or even years between times when a home is empty and in need of marketing.

What this ultimately means is that you need efficient, unique and fast-acting advertisement strategies that get your message out to locals when homes are available, and not when they aren’t. In addition to the popular home-listing sites, social media is perfect for this approach. It gives you fast, widespread access to locals who may be looking for new homes and helps you make use of any online networking you’ve already done. Let’s explore a few social media techniques that can draw attention to an available home in a friendly and welcoming way.

Change Your Page Banner

For many social media platforms, you can set a personal page or channel banner image that shows a large picture on your profile. As an individual, you may have used this for pictures of family, travel photos, pets or a hobby you’re involved in. But when you’re tenant-hunting, try a different approach.

Replace your page banner with a picture of the home from the perspective of your “for rent” sign. Try to get an attractive shot that makes it absolutely clear that the home featured is available for a new renter. There will be no confusion that anyone interested in renting should contact you through your social media account.

Pin A Gallery Of Photos

Several platforms allow you to “pin” a favorite recent post and essentially stick it to the top of your feed or profile page to share with everyone who comes along. When turning over a rental property is the perfect time to update your active pin to showcase more pictures of the home. Start with a picturesque outdoor or living room shot, and include a few of your best interior photos — as many as the platform will allow.

Include a small, simple caption that says the home is currently available for rent and how to contact you. Making use of your current personal social media account is a great way to get the word out to friends, family, contacts and tertiary contacts who may be interested.

The Right Tags And Hashtags

Tagging is how people on social media find new content from people they haven’t met and connected with before. Someone who wants to see discussions on their favorite TV show will look up the corresponding tag. Likewise, people looking for a rental home will check the tags and hashtags associated with renting and their region.

Depending on your platform, the best way to use tagging can be to create a connection with venues and local landmarks you want to reference when marketing your home. Tagging the community parks, local restaurants and neighborhood schools is a great way to get attention from people who are already involved and interested in your community.

Share Vacancies

While it might be obvious why connecting with potential renters is valuable, there’s also a strong advantage to joining a few landlord and/or property manager social media groups. These online communities often share each other’s listings. Landlords and property managers can work together to expand your group’s total networking reach by liking and sharing the listings other members post to the group. This can ensure that your properties are seen by a wider range of people and can give you an insight on the total rental market in your region.

Combine Online And Real-World Networking

Don’t forget that connecting with locals online is the path to real-world connections. Use social media to meet people in person. Invite local renters to join you for open houses or private showings. You might consider asking a few of your real estate industry professional contacts out to lunch. This can significantly strengthen your connection and give you a good idea of how much you can rely on each relationship.

People who really want to meet you in person are more likely to be eager and ready to take action, but be considerate of introverts who can be decisive but not social. You may also consider becoming a part of community events, both sharing information online and attending the event to casually meet more locals.

Respond To Messages

Finally, remember to check and answer every message you get on every channel. Watch your phone, email and private messaging system on every social media platform. There may even be messages on your property listing websites. Interested potential tenants can come from any direction, and you need to be responsive to win their confidence in the home itself. Don’t delay by more than 16 hours or a reasonable weekend to respond.

Try to give a polite answer to every message you get, and have a quick way to send them a copy of your application — ideally via text or email, as online applications can greatly streamline the process. Be ready to answer questions, provide links to photo galleries and send next steps to people as smoothly as possible, no matter how they contact you. And most importantly, be responsive and friendly. Remember that you’re also interviewing to be their new landlord or property manager.

Social media marketing for your rental properties needs to be a careful balance between a big splash and a polite invitation. By featuring your property on your page, reaching out to the community and meeting connections in person, you should be able to cast a wide net and find a tenant efficiently.

 

Warehouse Demand Continues To Drive Down Vacancy Nationwide

Industrial Property News

Despite global economic concerns regarding President Donald Trump’s trade wars, the logistics business just keeps on chugging.

Wikimedia/CTsabre14 Industrial real estate in the United States saw its 33rd straight quarter of declining vacancy nationwide with the close of this year’s third quarter, according to a CBRE report.

Vacancy dropped 33 basis points from Q3 2017, and 11 basis points from this year’s second quarter. CBRE calculates that the national industrial vacancy rate has hit 7.2%, its lowest level since 2000.

Unsurprisingly, consistent growth in the sector has been driven by e-commerce and its effect on brick-and-mortar retailers who have had to revamp their supply chains to keep up with the likes of Amazon, the Wall Street Journal reports.

Amazon has driven a sizable chunk of demand all on its own, capped off by the recent revelation that it is planning massive, multistory distribution centers all over the country.

Senior Managing Director, Capital Markets, TruAmerica Without the deep pockets that Jeff Bezos’ behemoth enjoys, other companies have been snapping up available warehouses faster than they can be built or staffed.

Though tariffs imposed by the U.S. government have driven up the cost of many materials needed for construction, they have not slowed down international shipping yet.

The National Retail Federation found that major U.S. seaports took in 2.7% more imports in September of this year than they had in the same month last year, the WSJ reports, which could be due to some companies’ accelerating holiday orders into the summer to avoid possible further tariffs.

Five Steps to Smart Multifamily Investments

Multifamily Investing 

The signs all point to an excellent opportunity for investment in multifamily rental properties. But while the overall outlook may be favorable.

A growing market. Who are the renters? Working-class individuals have traditionally been a mainstay of apartment living, but we now have to consider the millennial generation, consisting of 85 million U.S. citizens born between 1977 and 1996. Whether due to student debt or the delay in starting a family, this large segment of the population is a big factor in the increasing demand for apartments nationwide.

Investing in a new complex. In response to the growing number of people who prefer to rent rather than buy a home, new, shiny apartment communities are being built in cities across the nation.

Increased demand for class-B and -C apartments. With minimal investment in upgrades and amenities, the older class-B and -C complexes can attract a wide demographic, including working-class individuals and millennials. For one thing, they are generally located in established middle-income neighborhoods. In addition, these apartment complexes are essentially recession-proof, which is important for tenant retention when the economy heads south.

Lower initial costs lead to greater long-term returns. Older complexes are often undervalued or overlooked by institutional buyers due to the significant investment in time and resources required to reposition the property. A smart investor will see the opportunity here, since by investing in the right kinds of upgrades and addressing maintenance and safety issues, these buildings can yield greater returns, significant NOI growth and overall capital appreciation.

The importance of professional management. Many of these older units suffer from absentee ownership, misalignment between owner and property manager or unsophisticated owners/operators who lack professionalism and an institutional approach. Simply upgrading the units is not enough to improve value; professional property management is essential to protecting your investment. These days, that means more than simply keeping the property clean and attractive, although those things are important; it also means working to make your tenants feel like part of a community. That takes an experienced, professional management team.

Coupling an institutional investment approach with active, hands-on property management is what makes for a successful multifamily investment. Ultimately, if people feel safe and comfortable in their apartment community, they will want to stay—and that benefits everyone.

 

Multifamily Investing Due Diligence Do’s and Don’ts

With historically high rents fueling the apartment market, sellers are once again demanding top dollar and buyers have become increasingly aggressive in their pursuit of available inventory. During this process, the prevalence of defective construction in the apartment industry over the past several decades should not be overlooked.

Amateurs and professionals alike have purchased properties that were economic disasters because they were fraught with undetected construction defects. As a consequence, conducting thorough “due diligence” investigations are essential in avoiding the substantial repair and maintenance costs that can result from latent construction defects.

Understanding Apartment Construction

As owners and operators know, apartments are hybrid commercial/residential projects that have a history of problems unique to their classification. Making sure that a buyer, or a buyer’s inspection company, understands these problems, and where and how they manifest in apartment construction, can make or break a due diligence investigation.

Even reputable commercial inspection companies focus their due diligence investigations on interior systems, such as mechanical and plumbing systems, and generic sources of water intrusion common to all construction (roofs and windows). It’s doubtful, however, that these inspectors will discern hidden points of water intrusion such as handrails, deck edges, and stair stringers. Thus, it’s important the investigator be aware of not only how and where water penetrates, but how evidence of that water penetration—even when hidden behind finish materials like concrete and stucco—manifests itself on the finished surfaces of the building.

Forensic investigators who provide support to attorneys can be an excellent resource for buyers, too, during the due diligence process. They can, for example, review a building’s architectural plans for common architectural details that can allow water intrusion. They can also walk a project and identify areas that have a high probability of leaking, without conducting destructive and costly testing. If destructive testing is necessary, the forensic investigator can perform the testing and provide estimates the buyer can then use in soliciting bids for the repair work. The investigator’s findings can also help the buyer evaluate the economics of the purchase and renegotiate the sale price, if desired.

Understanding the Construction Team

An apartment building’s original construction documents are commonly made available as part of the due diligence process and should contain design drawings, subcontracts, and prime contracts, at the very least. These files can answer many questions you, as a buyer, may have, including the following:

First, ask whether the builder built the property for the builder’s own profit. Some extremely reputable developers occasionally function as their own general contractors. This is a red flag that should trigger caution, because the economics of development can be in conflict with the time and cost requirements of contractors. When developers act as their own general contractors, there’s an increased probability that quality control will suffer for the sake of maintaining the development pro forma and schedule. This is particularly true if the developer didn’t “hold” the asset for a significant amount of time after it was built.

Second, ask about the design professionals who worked on the job. Different firms have different reputations. Some architectural firms are better at generating plans that are more subcontractor–user-friendly than other firms. If the plans are too complicated, it’s common for subcontractors to ignore them.

Third, ask about the subcontractors who were retained to perform the construction work. Among the major trades, such as framing, waterproofing, sheet metal, and lightweight concrete, how many of those subs are still in business? What was their reputation when they worked on the project?

Trade contractors tend to use the same means and methods on every project they work on, often despite the requirements of their contract documents. It would astound the common consumer to learn how frequently trade contractors ignore essential contract drawings and specifications. As a consequence, a builder’s habits tend to carry over from project to project, good and bad. Attorneys and inspectors who work with apartment owners in your region should know who they are.

Understanding the Maintenance History

Because purchase and sale agreements commonly have limited representations and warranties, buyers should seek to gain as much “actual knowledge” about the function of the project as possible. Maintenance records are often the most important records for ascertaining this information, yet they are commonly ignored.

Patterns in maintenance records can provide valuable insight into which, if any, of the building’s systems aren’t performing. For example, is there a history of complaints of water coming through door thresholds or windows? Are there particular units with multiple maintenance requests for mold abatement? Is there a correlation between maintenance requests in a particular place (such as on a certain floor, or facing one particular orientation)? The problem may lie not with the tenants but with the system itself.

Talk to the maintenance personnel. What do they think works well and not so well at the property? On one occasion, a client of ours was horrified to learn that a team of painters did nothing but caulk and paint siding, because of installation errors in the building envelope. The buyer never bothered interviewing any members of the maintenance staff, some of whom freely volunteered to lawyers in subsequent litigation that the project was referred to as the Golden Gate Bridge because the asset was perpetually being painted.

Understanding Claims Preservation

Besides the building, its construction team, and the maintenance staff, there are three important legal theories apartment buyers should be aware of prior to closing escrow on a property.

Ten-year defective-construction limit. There is an absolute bar against suing a builder for defective construction more than 10 years after the project was completed. As a consequence, when a purchaser fails to identify defective construction in older properties, there can be no recovery against the builder to help offset repair costs, making thorough and effective due diligence inspections all the more important.

Three-year potential claims limit. For projects less than 10 years old, claims for construction defects can nonetheless become time barred if not pursued within three years of when an owner knew or should have known that the defect existed. Moreover, when a buyer purchases a piece of real property, the buyer is charged with the knowledge of the prior owner. Thus, if a prior owner discovers or should have discovered defective workmanship, the statute-of-limitations period commences as to that owner and all future owners.

Limits of transference. The right to sue for defective construction is a personal property right that does not automatically transfer with the sale of the real property. To the contrary, if a seller is aware of defective construction prior to the close of escrow and does not specifically transfer the legal right to sue for that defective construction (through a document called an “assignment of choses in action”), the right remains the personal property of the seller, and the buyer will have no recourse against the builder.

By conducting a thorough review of the project file, maintenance materials, and any prior sales documents, an apartment buyer should be able to determine whether the seller discovered or should have discovered any defects at the property. However, as a matter of course, purchasers of property less than 10 years old should demand that assignments of choses of action be included in the closing documents.

Good due diligence requires patience, hard work, and professionals who possess the expertise to correctly advise their clients. A proper investigation yields a thorough understanding of the building’s construction and maintenance history as well as the available rights to be conveyed.

CMBS Loans

Anyone advocating for a commercial real estate borrower — especially mortgage brokers and lenders who influence the front end of a loan scenario — should be aware of some common misconceptions about cash management for loans underpinned by commercial mortgage-backed securities (CMBS).

About 70 percent of all CMBS loans originated-ed today have some sort of cash-management system, or lockbox, that allows a lender to capture a property’s cash flow. Understanding “springing” lockboxes, which are especially common, can help borrowers avoid deals that start well but wind up going bad.

There are three types of cash-management systems for CMBS loans. They include hard lockboxes, which do not allow the borrower to have control over the property’s cash flow; soft lockboxes, which allow some control of cash flow; and springing lockboxes, which are triggered when certain situations occur.

The general premise of springing cash management is that it gives lenders the power to capture cash flow in the event of declining property performance. Mortgage brokers and borrowers may agree with this premise and understand its intent when they sign a deal with springing cash-management provisions, but it’s important to remember the devil is in the details.

Income restrictions

Some borrowers think they won’t need to worry about cash management springing on their loan if the property is performing well and the debt-service coverage ratio (DSCR) is above the threshold spelled out in the loan agreement.

Typical CMBS loan agreements, however, include many definitions within definitions that give the servicer the right to calculate DSCR, and the servicer’s calculation is “final absent a manifest error.” These words actually appear in many loan agreements and the definitions are very important as they state what should be included in both the income and expense components of the DSCR calculation. With interest-only loans, the debt service used in the DSCR calculation often assumes the loan is of the 30-year amortizing variety, making the monthly payments in the formula much higher than interest-only payments.

Mortgage brokers and their clients should know about income that may be excluded from the DSCR calculation in the typical CMBS loan agreement.

The bottom line is there are many well-performing properties today with DSCRs of 1.5 and higher that are being placed into cash-management plans. This is because the servicer has performed its own calculation based on the specific details of the loan agreement and is excluding certain income line items, adding other expenses and using an amortizing payment plan (even for interest-only loans). The servicer’s DSCR is often much lower than the actual ratio. Again, however, the servicer’s numbers are final, absent an obvious error. Just because the actual DSCR is above the documented threshold for springing cash management, it doesn’t mean the servicer’s calculation won’t be below the threshold.

Occupancy and rental rates

A second misconception is that a borrower won’t need to worry about cash management when his or her property is outperforming market expectations because of higher occupancy rates or higher rental rates.

“Underwritten operating income” is a term often included in the details of the servicer’s DSCR calculations. This stipulation allows the servicer to adjust rental rates, occupancy rates and other factors to the lower of (a) actual, (b) market, or (c) underwritten rates. So, in cases where the borrower has negotiated higher-than-market rental rates or has an occupancy rate above the market average, they will not get credit for that when the servicer calculates their DSCR as it relates to cash management.

This can really sting a borrower, for example, if the loan was originated with an underwritten occupancy rate of 80 percent, but the current occupancy is 90 percent. If the loan agreement defines the occupancy rate as the lower of actual, market or underwritten rates, then the income will always be calculated assuming 80 percent occupancy — or lower, if market-rate occupancy is below that — regardless of the actual occupancy rate of 90 percent.

Once again, just because the actual DSCR is above the documented threshold for springing cash management, it doesn’t mean the servicer’s DSCR calculation won’t be below the threshold and cause the lockbox to be sprung. Income will be adjusted downward to the lowest allowable number in the loan documents.

Loan assumptions

Many buyers entering into an assumption of an existing loan believe they will receive the same terms as the previous borrower. This is partially true — but not entirely — and this one issue causes many lawsuits between buyers and sellers when the conditions for approval contain what the buyer believes are deal changes.

Without a modification, there are loan-assumption terms that cannot change, such as the interest rate and maturity date. There are other requirements that are wide open to change, however.

Reserves. Servicers can add reserve requirements that aren’t in the current loan documents, and they can increase the amount of reserves as much as they feel warranted. Often, any caps in place on the reserves are removed at the time of assumption.

Additional collateral. This can be in the form of a cash reserve, a letter of credit or a personal guarantee. The point is that the servicer can request additional collateral from the assuming borrower for any number of reasons — or no perceived reason at all.

Cash management. If the loan includes springing cash management, you can bet that it will be sprung at the time of assumption, regardless of the property’s performance. In today’s marketplace, this is a common condition for loan-assumption approvals.

Don’t be fooled into thinking a buyer can request changes to the loan documents at the time of assumption. A servicer is unlikely to entertain changes requested by the borrower. When buying a property with existing CMBS debt, mortgage brokers and their clients should be prepared for higher reserve amounts, cash management and other conditions. Don’t expect to be able to change the loan documents.

Purchase-price adjustments

When a buyer assumes an existing CMBS loan, they may believe the purchase price of the property doesn’t matter since the loan is already in place. This used to be the case. From 2009 to 2014, loan-to-value (LTV) ratios at the time of assumption didn’t matter.

But times have changed. Some special servicers now require a buyer to establish a reserve at the time of assumption in order to make the LTV equal to the original loan-to-purchase (LTP) ratio. This is best understood with an example.

Let’s say a CMBS loan was originated on a property with an appraised value of $25 million and the borrower got a 65 percent LTV loan — $16.25 million — at that time. Fast forward a few years and the property is being sold to a new buyer for $22 million. The original loan is interest-only, so the total balance is still $16.25 million.

On a property valued at $22 million, a 65 percent LTV loan would equal $14.3 million. Since the current loan is for $16.25 million, however, the difference between $16.25 million and $14.3 million ($1.95 million) would be required in the form of a collateral reserve at the closing of the loan assumption.

To make matters worse from a borrower’s perspective, the $1.95 million cannot be used to pay down the loan because CMBS loans have prepayment prohibitions or penalties. So, the $1.95 million sits in a reserve account and cannot be used by the buyer for the life of the loan. This one item can impact a buyer’s internal rate of return so severely that many back out of deals when they learn of this requirement.

What does all this mean for commercial mortgage brokers and their clients? Don’t enter into new CMBS loan documents without a thorough understanding of the specific terms, definitions and servicer processes. Don’t assume cash management will not be sprung based on actual DSCR calculations. This decision is based on the servicer’s DSCR calculation, which is binding unless there is an obvious error.

Be prepared for additional cash requirements when a buyer is assuming an existing CMBS loan, including the possibility of an LTV reserve. And, most of all, know that every word in the loan documents matters in regard to springing cash-management and DSCR calculations.

 

Loan-To-Cost Ratio LTC Explained Winston Rowe and Associates

What is Loan To Cost Ratio LTC

The loan-to-cost (LTC) ratio is a metric used in commercial real estate construction to compare the financing of a project (as offered by a loan) with the cost of building the project.

The LTC ratio allows commercial real estate lenders to determine the risk of offering a construction loan. Similar to the LTC ratio, the loan-to-value (LTV) ratio compares the construction loan amount with the fair-market value of the project.

The LTC ratio is used to calculate the percentage of a loan or the amount that a lender is willing to provide to finance a project based on the hard cost of the construction budget. After the construction has been completed, the entire project will have a new value. For this reason, the LTC ratio and the LTV ratio are used side by side in commercial real estate construction.

Example

Assume that the hard construction cost of a commercial real estate project is $200,000. To ensure that the borrower has some equity at stake in the project, the lender provides a $160,000 loan.

This keeps the project slightly more balanced and encourages the borrower to see the project through. The LTC ratio on this project is 80 percent.

Loan-to-Value Ratio

The LTV ratio compares the total loan given for a project against the value of the project after completion. Considering the above example, assume that the future value of the project, once completed, is double the hard construction costs.

If the total loan given for the project, after completion, is $320,000, the LTV ratio for this project is also 80 percent.

Significance to Lenders

The LTC ratio helps to delineate the risk or risk level of providing financing for a construction project.

Ultimately, a higher LTC ratio means that it is a riskier venture for lenders. Most lenders provide loans that finance only a certain percentage of a project.

In general, most lenders finance up to 80 percent of a project. Some lenders finance a greater percentage, but this typically involves a significantly higher interest rate.

While the LTC ratio – as well as the LTV ratio – are both mitigating factors for lenders that are considering the provision of a loan, they must also consider other factors.

Lenders consider the location and value of the property on which the project is being built, the credibility and experience of builders, and the borrowers’ credit record and loan history as well.

How Commercial Construction Loans Work

Securing a commercial construction loan for various types of commercial real estate can be a difficult process to navigate. This post will shed some light on commercial construction loans and demystify the lending process.

Commercial Construction Loans and Lenders

The construction loan process begins when a developer submits a loan request with a lender. Construction or development lenders are almost always local community and regional banks.

Historically this was due to bank regulation that restricted trade areas for lending. More recently, life insurance companies, national banks, and other specialty finance companies have also started making construction loans.

However, community and regional banks still provide the majority of construction financing, since they have a much better understanding of local market conditions and the reputation of real estate developers than larger out of area banks.

There are two normally two loans required to finance a real estate development project, although sometimes these two loans will also be combined into one:

Short term financing. This stage of financing funds the construction and lease up phase of the project.

Long term permanent financing. After a project achieves “stabilization” and leases up to the market level of occupancy, the construction loan is “taken out” by longer term financing.

When a bank combines these two loans into one it’s usually in the form of a construction and mini-perm loan. The mini-perm is financing that takes out the construction loan, but is shorter in duration than traditional permanent financing.

The purpose of the mini-perm is to pay off the construction loan and provide the project with an operating history prior to refinancing in the perm market.

Commercial Construction Loan Underwriting

After the initial loan request is submitted, the bank typically goes through a quick internal go/no-go decision process.

If the project is given the go-ahead by the bank’s senior lender, the lender will sometimes issue a term sheet which outlines the terms and conditions of the proposed loan, provided all of the information presented is accurate and reasonable.

Once the non-binding term sheet has been reviewed, negotiated, and accepted, the lender will move forward with a full underwriting and approval of the proposed loan.

During the underwriting process the lender will evaluate the proposed project’s proforma, the details of the construction budget, the local market conditions, the development team and financial capacity of the guarantors, and in general address any other risks inherent in the loan request.

Typical documents required in the underwriting process include borrower/guarantor tax returns, financial statements, a schedule of real estate owned and contingent liabilities for the guarantor(s), the proposed project’s proforma, construction loan sources and uses, cost estimates, full project plans, engineering specifications, and in general, any other documents that can support the loan request.

From an underwriting standpoint, one of the most notable differences between a commercial construction loan and an investment real estate loan is that with a construction loan there is no operating history to underwrite.

The economics of the project, and thus the valuation of the property, is based solely on the real estate proforma.

The credit approval process is similar to other commercial loans, but because of the additional risks inherent in construction loans, further consideration is given to the development team and general contractor, as well as the prevailing market conditions.

Once the commercial construction loan is approved, the bank will issue a binding commitment letter to the borrower.

The commitment letter is similar to the term sheet, but contains much more detail about the terms of the loan.

Additionally, the commitment letter is a legally-binding contract whereas the term sheet is non-binding.

Commercial Construction Loan Closing and Beyond

Upon completion of the loan underwriting and approval, a loan then moves into the closing process, which can take on a life of its own.

Commercial construction loan closings are complex and involve an overwhelming quantity of documentation and procedural nuances. Typically, the closing is handled by the lender’s attorney, the borrower, and the borrower’s attorney.

A loan closing checklist is also normally issued to the developer along with the commitment letter, which outlines in detail what needs to be completed before the loan can close and funding can begin.

After a loan closes, the loan mechanics are primarily the responsibility of the loan administration department within a bank.

The loan administers (sometimes just called the loan admin), will fund the loan according to the internal policies and procedures of the bank.

Commercial construction loans are typically funded partially at closing to cover previously paid soft and hard costs.

After the initial partial funding, loan proceeds are disbursed monthly based on draw requests for costs incurred. These costs are submitted by the developer and verified by the lender.

Commercial construction loans can quickly become complex and difficult to secure. But understanding how construction loans work and how commercial developments are evaluated by lenders can help demystify the funding process.

In future posts we’ll dive into various parts of this process in detail. In the meantime, if you have any specific questions about commercial construction loans, please let us know in the comments below.

Commercial Loan Due Diligence Approach and Methodology

Due diligence is an important exercise in a loan transaction because it allows the lender to make an informed decision as to whether it should lend money to the borrower and, if so, on what terms. A thorough due diligence review of the borrower and its business ensures that the loan does not involve legal risks that the lender is unaware of that could endanger the repayment of its loan. Due diligence is an effective tool for uncovering aspects of the borrower’s business that can either:

Introduce new negotiating points for the pricing and terms of the loan.

Lead to changes to:

the collateral package that secures the loan; or

other credit support for the borrower’s repayment obligations, such as guarantees or insurance.

Cause the lender to withdraw from the deal.

The failure to identify significant legal risks in a loan transaction can cause problems for a lender, ranging from an unfavorable business transaction to legal liability and the obligation to pay damages.

The scope of a due diligence investigation is driven by:

The type of transaction.

The parties involved.

The level of risk the lender is willing to assume.

Counsel must know which questions to ask and the proper steps to follow to carry out a sufficiently detailed review that serves their clients’ interests. Due diligence typically involves a large number of documents that must be exchanged and carefully examined. This often requires coordination of a team of reviewing attorneys, good organizational skills and planning a well-defined scope to the due diligence exercise.

Depending on the transaction and the nature of the borrower’s business, due diligence concerns may vary. For example, a lender’s credit analysis and due diligence review of a business with extensive real estate holdings will focus on different issues than a lender’s credit analysis and due diligence review of a holding company with assets consisting largely of securities in subsidiaries and intellectual property.