In the Question and Answer segment of Webcast on Commercial Real Estate on March 19th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Q: Is current vacancy considered "stabilized"?

A:  Usually not.  “Stabilized” is a term used by an appraiser to designate a value at the point of equilibrium for the market in question.  The existing vacancy rate may turn out to be identical to the appraiser’s assessment of a “stabilized” vacancy rate at the point of market equilibrium.  The same considerations would apply to existing and “stabilized” rental rates and to existing and “stabilized” operating expenses.

Q: If property is 100% occupied by a single tenant, does the lease term play a more important role?

A: The lease term would play a critical role.  This is a concentrated customer base, so to speak, and if anything happens to the single customer, the property could encounter rather massive cash flow problems.  For a single tenant, it is always important to match the term of the lease with the amortization period – the more closely they match, the better for the property, for property cash flow, and for debt service.

Note, too, how important the financial health and prospects of the single tenant are to the financial health and prospects for the property.  It’s usually very difficult to get relevant information about a single tenant, even if it is a location of a larger retail chain that is publicly listed.  The publicly listed company may be quite robust while its local outlet in this instance is struggling badly.  Depending on the specific lessee, the larger company may not be a source of financial support in bad times.

Q: Do you provide a template that would calculate the various break even scenarios?

A: We offer such a template as part of our Resource Center, which is available to
organization members.

Q: What is IREM?

A: IREM is the acronym for the Institute for Real Estate Management.  Among other things, it plays a role in the commercial real estate world similar to a role played by the RMA in the commercial business world.  That is, the IREM conducts surveys about vacancy rates, rental rates, and operating expenses in various metropolitan areas and sub-areas.  It provides the results of those surveys to members who may then use the results for comparative purposes – rather like comparing a property’s vacancy rate, rental rate, and set of operating expenses with its peers in the local market.

Q: How do you derive the 'debt constant'?

A: The debt constant comes from a fairly complex formula that reduces to a number for each interest rate and amortization period for either annual, semi-annual, quarterly or monthly mortgage payments – or for any other debt repayment frequency you wish.  The appropriate constant is then multiplied by the loan amount to provide the periodic payment.  The conceptual formula underlies the mechanics that transpire when you enter the loan amount, the interest rate, the amortization period, and the payment frequency into any calculator that supports that function.  In addition, debt constant tables are widely available from a variety of sources, accessible via the Internet and a Google search.

Q: If you feel the collateral value is the 3rd repayment option (tertiary), what do you see or hear the FDIC feels in today's economic times?

A: I don’t hear anything that provides great clarity about the issue.  From all comments
I’ve received, the regulators would tend to allow collateral value to trump net operating income, i.e., if a property had sufficient cash flow to service debt but had more debt on the property than an estimate of current market value, the regulators would tend to consider the property an impaired asset.  Personally, I think this makes little sense.  The first way out for a performing asset is sufficient cash flow to service interest-bearing debt.  If an income producing property is, indeed, providing sufficient net operating income to do so, that should be the relevant consideration in assessing loan performance – not some fleeting estimate of collateral value.

Q: Does FIRREA require new appraisals on loan modifications vs. refinances?

A: A very good question but one I think should be properly answered by the regulators.  I suspect it depends on the extent of the loan modifications.  If those modifications changed the debt service obligations and periodic payment amounts, they would likely be considered a de facto re-financing.  But if loan modifications impacted other elements of the financing, such as payment dates or reporting requirements, then I would guess that a FIRREA-driven appraisal would not apply.

Q: On the Reasonable Tests, you compare the cap rate to prime rate and Baa yields. How does the prime rate relate to assessing reasonableness to the cap rate used?

A:  I use Baa yields – or, better, junk bond yields – to approximate the risk associated with investment in income producing properties.  The prime rate presumably represents the rate applied to the highest credit quality.  Therefore, it would not represent the required yield on a comparable risk asset.

However, a very relevant issue is whether the capitalization rate on an income producing property is greater or less than Baa or junk bond yields.  If it is less, that implies the investor expects to make up his or her required yield via property appreciation.  If it is more, that implies the investor expects to suffer a decrease in property values and, hence, a reduction in overall yield.

If you wish, you could compare a capitalization rate to the prime rate as a very rough guide about investor price expectations.  If the capitalization rate ever fell below the prime rate, it would represent a very strong signal that the investor expected significant price appreciation in the underlying asset.  In more normal circumstances, we would expect the capitalization rate to be higher – by some considerable margin – than the prime rate.

Q: Why did we assume a 5% interest rate on the Proposed Refinancing vs. 8.5% at origination, whereas the cap rate was higher by .25%.

A: The applicable interest rate represents, primarily, the cost of money plus a risk premium.  In mid 2007, five year LIBOR was about 5.75%.  In January 2009, five year LIBOR was about 2.25%.  If the lender funded itself at a five year LIBOR rate in June 2007, its spread would have been 275 basis points with the transaction lending rate set at 8.50%.  By the same token, if the lender funded itself, again, at a five year LIBOR rate in January 2009, its spread would be an identical 275 basis points even though the lending rate had dropped to 5.00%.

The capitalization rate did not change.  It remained at 9.50% for both financings, in the opinion of the appraiser.  However, a 9.50% cap rate in January 2009 in a much lower interest rate environment represents a considerably higher risk premium than did a 9.50% cap rate in June 2007.  In June 2007, the prime rate was 8.25%.  In January 2009, it was 3.25%.  In general, there is a high level co-relation between movements in market interest rates and movements in capitalization rates.   But capitalization rates should be very specific to the property in question, in addition to reflecting the general interest rate environment. 

With respect to 1200 Columbia Pike, the appraiser obviously felt a relatively higher capitalization rate was appropriate and, therefore, kept it at 9.5%, although the general interest levels had dropped dramatically from those prevailing at the time of the initial June 2007 financing.

In the Question and Answer segment of Webcast on the Credit Write-up on March 12th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Tony asks: During an economic downturn, can one assume that the business will return to prior levels of sales and income?

A: I don’t think so.  In fact, the economic downturn will likely lead to a major restructuring of the U.S. economy.  A company that did well prior to the downturn may be poorly positioned to do well as the economy rebounds.  There have been several interesting articles lately about the possible fallout of the present recession.  Some geographical areas will likely emerge far stronger when the economy emerges from its present depressed state – especially those areas that have a highly educated workforce and a synergy of technical and administrative competence.  Other areas will continue to decline and suffer extensive job losses.  The bottom line is that all bets are off.  The post-recession world may be very different from the pre-recession world. And what worked before the recession may not work after the recession ends.

Tony asks: Borrower concurrence in this case means that the borrower needs to come up with an additional $200,000 down payment. Shouldn’t this be discussed as a major point as well?

A: Absolutely.  The deal may fall apart if the lender is unwilling to provide more than $800,000 of term financing for a property selling for $1,365,874.  The buyer must now provide an additional $224,406 of equity (the difference between $1,024,406 – 75% of $1,365,874 – and the $800,000 the lender is now willing to provide).  Whether the buyer is willing to do so is a critical issue.  But, presumably, the lender is willing to walk away from the deal if the buyer will not, or cannot, provide the additional cash necessary to make the transaction work.

Antonio asks: The seven-day decrease in A/R days resulted in a cash inflow of $304,152.  How did you determine that amount?

A:  The solutions provide the computations in some detail. Briefly, however, the $304,152 represents the difference between the accounts receivable balance in 2005 if receivables had grown at the 2005 sales growth rate of 47.33% and the actual 2005 ending balance. 

If receivables had grown at 47.33%, accounts receivable days would have remained at 35 days (actually at 34.57 days) and the 2005 receivables balance would have been $1,488,624.  In fact, receivables did not grow at the sales growth rate. They grew at a lesser rate since the company collected its receivables seven days more rapidly.  As a result, the ending 2005 accounts receivables balance was $1,148,472.  The difference between 2005 accounts receivable at 35 days and actual 2005 accounts receivable at 28 days was $304,152 or $1,488,624 – $1,148,472.

Antonio asks: What is the difference between Stabilized NOI and actual NOI?

A:  Stabilized net operating income (NOI) represents the NOI that the property would be expected to generate at the point of equilibrium – which would occur at some future point in time.  It’s customary and conventional for appraisers to assess the rental rate, the vacancy rate, and the operating expenses at the point of equilibrium, which is usually different from the state of affairs at the time of the appraisal.  Those three assumptions collectively determine stabilized NOI.

Actual NOI is the present net operating income of the property.  Stabilized and actual NOI may be significantly different for a variety of reasons.  The critical point, however, is that actual or current NOI is the property cash flow available to service interest-bearing debt.  Stabilized NOI is a future, and rather idealized, concept.  It may or may not ever materialize.

Antonio asks: What about the owner's credit worthiness?

A: The property owner’s credit worthiness is certainly a key factor.  But an equally as pressing problem is an assessment of the amount of ready cash the owner could provide in a financial crisis to support the property’s debt service.  In the best of all worlds, the owner would be highly credit worthy as well as able to access highly liquid personal assets to support the property’s debt service in the event of difficulties. 

Assessing ready cash is far more complex than identifying an owner’s estimate of net worth on his or her annual personal financial statement.  It requires a close and frequent review of the owner’s personal assets, usually by reference to monthly or quarterly bank or broker statements.  To the extent the property’s net operating income is marginal or diminishing, the value of the personal guarantee becomes increasingly important – which means that a current assessment of that guarantee becomes increasingly important.

Cecil asks: How do you treat taxes on DCR for Subchapter C corporations?

A: Since income taxes are paid directly by a Subchapter C corporation, net income will include the income tax expense.  Therefore, you need make no adjustment to net income for income taxes if, for example, you used net income as your starting point in structuring a debt coverage ratio.  In such a case, net income would need to be sufficient to cover scheduled long-term debt repayment.  To be safe, you should also specify that net income must exceed the sum of scheduled debt repayment and loans to owners.  Such loans do indeed exist for Subchapter C corporations, just as they do for all other types of business organizations.

If you chose to use EBITDA as your starting point for a debt coverage ratio, then EBITDA would need to be sufficient to cover income taxes, interest expense, scheduled long-term debt repayment and loans to owners.  In this instance, income taxes are identified separately, since they are not included in EBITDA.

In the Question and Answer segment of Webcast on Estimating Debt Capacity on February 26th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Cathy asks:  The Due to Shareholders account increased from $57,931 in 2007 to $202,397 in 2008.  Would that amount be added to the amount of cash available to service debt? 

Answer: The $144,466 cash inflow from a shareholder in the form of a loan to the company is not part of operating profit or operating cash flow.  It plays no role in estimating Sierra Products’ debt capacity in 2008.

However, the cash inflow from the loan represents financing, and, as the 2008 UCA cash flow statement indicates, reduced the company’s need for outside financing by the amount of the loan, i.e., by $144,466.  Apart from that cash inflow, Sierra Products was compelled to raise a further $413,992 of short-term debt and $314,000 of new long-term debt to meet its shortfall – an increase in outside party interest-bearing debt of $727,992.

Whether it used any of the shareholder loan for debt service is unclear.  Very likely it used additional short-term debt to meet its debt service shortfall of $297,607 at Cash after Debt Repayment. The remainder of the increase in short-term debt of $116,385, the new long-term debt of $314,000, and the $144,466 loan from the shareholder probably represent the company’s cash sources in 2008 to pay for $587,082 of fixed asset acquisition.  The sum of those three cash sources is $574,851 – $12,231 less than the amount required.  The additional $12,231 came from the company’s existing cash balances.

In general, consider loans to owners or shareholders as compensation.  It’s an easy and quick way to pull money from a company.  Consider loans from owners or shareholders as “emergency” financing.  That is, the company could not arrange the outside financing it needed and, in the final analysis, was compelled to rely on the owner’s resources.

Melissa asks: In computing an appropriate leverage ratio, would you adjust net worth down or exclude the difference between due from and due to shareholders?

Answer:  It might be a bit more transparent to reduce net worth by the amount of the Due from Shareholders balance, i.e., treat the amount due from owners or shareholders as an intangible.  Such a reduction to net worth would increase the leverage ratio, which is appropriate since this type of expense signals an increase in risk. 

On the other hand, you would reduce total liabilities by the amount of the Due to Shareholders balance – if all loans from shareholders are subordinated – and add the Due to Shareholders balance to net worth.  The underlying assumption is that subordinated debt is similar to equity, particularly if a strong subordination agreement is in place and actively monitored.  This adjustment, in turn, decreases leverage, since it represents a quasi debt-to-equity switch.

In effect, you might apply a two-step approach.  First, consider the Due from Shareholders balance as an intangible asset and reduce net worth by the amount of the outstanding balance, which increases leverage.  Second, consider the Due to Shareholders balance as quasi equity, if a subordination agreement is in effect, and move the full balance from debt to equity in computing a leverage ratio. 

The two steps taken together should provide a fair representation of the change in risk, reflected in the leverage ratio, from loans to and loans from owners and shareholders.

But regardless of the impact on leverage, keep in mind that the immediate impact of a new loan to an owner or shareholder is to decrease debt capacity.

In the Question and Answer segment of Webcast on Commercial Real Estate on February 19th, we responded to the questions submitted.  However, we have repeated the questions (slightly edited in some instances) and have provided more detailed answers to each below.

Sam asks:   Can you expand on Class A commercial properties versus Class B commercial properties and the potential impact of the recession on each?  That is, some Class B may weather the storm better…particularly as big box stores close.

Answer:  I would tend to agree.  Tough times put a premium on lower rents and that suggests an advantage of Class B vis-à-vis Class A commercial properties.  In addition, Class A commercial properties may carry a relatively higher debt burden than Class B commercial properties, particularly if the Class A commercial properties are more recent.  The higher debt burden, if it does exist, suggests higher financial cost rigidities and less flexibility to reduce rents.

However, as with virtually all real estate issues, so much depends on local market conditions.  What might apply in one market may not apply in a neighboring market.

Melissa asks: Why use an appraisal for value with 5% vacancy when actual rent rolls represent a higher vacancy percentage?

Answer:  The appraiser attempts to determine a “stabilized” vacancy rate at the point of market equilibrium.  That “stabilized” rate may be far different from the prevailing vacancy rate at the time of the appraisal, which is quite common.  But the problem for the lender is that it has to contend with actual market events in attempting to determine if the property can cash flow, i.e., generate enough cash to properly service the debt.  Consequently, a “stabilized” vacancy rate, a “stabilized” rental rate, and a “stabilized” set of operating expenses are really irrelevant in assessing present – not “stabilized” – debt capacity.  My point is to always focus on current events and current net operating income and do not be lead astray by the prospects of what might be at some point in the future.

Amber asks:  If this is a subsequent transaction, why is a new appraisal required? This assumes an in-house evaluation/review indicates no substantial changes in market value from appraisal and no new funds are disbursed.

Answer: Given the terms and conditions specified in FIRREA, a lender must request a new appraisal for refinancing of an existing property if the refinancing amount exceeds a certain minimum, such as $500,000.  Your internal review may show no substantial change, but the examiners may emphasize the need for a new appraisal in the process of enforcing the provisions of FIRREA.

Melissa asks:  What is TI claw back?

Answer:  A TI claw back is a refund for tenant improvements (TI) that were initially paid for by the landlord but then charged back to the tenant in the form of an increase in the rental rate over some period of time.

Doug asks:  Do you have available canned formulas via Excel our another source to calculate the break-even figures?

Answer:  We have an electronic worksheet that provides numerous break-even computations as well as provides the format and process for computing estimates of market value using the income capitalization rate.  The worksheet is housed in our Resource Center and is available to Organization Members and Enterprise Wide Licensees. 

Kristi asks:  How would you assess an interest only situation?

Answer:  With care.  In the final analysis, the property must throw off enough cash to pay interest as well as meet required debt reductions.  Consequently, you might match projected net operating income against interest-only debt service over the interest-only debt service period and then match projected net operating income against full debt service from that point to maturity.  If you have any doubt that the property’s net operating income will not increase sufficiently to match full debt service, then be very careful about the transaction.  If you’re already in it, search for and identify all likely back-up sources of debt service, such as likely cash support from one or more guarantors.

An interest-only loan may look attractive today in a low interest-rate environment, but this low interest-rate environment finds itself in the midst of a severe economic recession that drives down rental rates and increases vacancy rates.  That, in turn, places a great premium on current information about the property, especially about existing rental rates, existing vacancy rates, and likely future vacancies.

Matt asks  On the 1/1/09 Columbia Pike rent roll, four vacancies are shown as opposed to the three that were referenced in the slides. Was the fourth vacancy (unit 210) accounted for in the analysis?

Answer:  It was accounted for in the analysis.  I simply overlooked the fourth vacancy in putting together my comments but did compute the effective gross income properly.

Peter asks:  Could you go over the revised estimate of market value calculation again?

Answer:  The intent of the revised approach to estimating market value via the income capitalization approach is to more correctly capture net operating income and an appropriate capitalization rate during a transition period to “stabilized” or market equilibrium. 

During that interim period, the task is to estimate net operating income as accurately as possible and to determine an appropriate capitalization rate for the subject property as accurately as possible.  A further task, which is much more difficult, is to estimate likely net operating income at the later point of market equilibrium and a capitalization rate at that later point of market equilibrium.  There are many historical markers to use as reference points for both a market equilibrium net operating income and capitalization rate but, nonetheless, the two values we decide on are only our best guesses at the time.

But the real advantage of this approach is that it attempts to better approximate what is happening today and what will likely happen tomorrow.  To apply a single capitalization rate to a single estimate of net operating income can be very misleading about market value over any time period – either misleadingly high or misleadingly low.

The equation below reflects our assumptions about working through a transition period for 1200 Columbia Pike.  Those assumptions, in turn, as are follows:

• The real estate market in the property’s area will not return to equilibrium until 2012.
• Over that three-year horizon, the appropriate cap rate is indeed 9.50%.
• NOI will remain at $81,091 over the three-year horizon, then jump to a stabilized value of only $103,515.
• At the point of market stability, the stabilized cap rate will fall to 7.00% for this market and property.

          $81,091        $81,091        $81,091           $103,515
Market Value = ———— + ———— + ———— + —————— = $1,410,580
         (1.095)         (1.095)²            (1.095)³        (1.07)³ x (0.07)

Once we work through all the computations, the present value of the property is $1,410,580, vastly in excess of our prior estimate of $982,921.  That estimate implicitly assumed that NOI would remain at $81,091 forever into the future.  It also implicitly assumed that the investor’s required rate of return on property NOI would remain at 8.25% forever into the future – both quite unrealistic assumptions. 

Jay asks:  If a bank has not traditionally done this type of self-underwriting, how do they undertake it in today's environment?

Answer:  The most practical approach may be to either engage a consultant who has worked as an underwriter for a real estate lender and, therefore, should understand the information and analytical requirements or bring someone on staff with those qualifications.  Hiring the expertise can frequently be a long and arduous task.  In the short run, it might make more sense to search for a qualified consultant.

Jay asks:  Is there a banking source or report, which estimates the percentage of loans under stress by region and/or banks?

Answer:  The Federal Deposit Insurance Corporation produces monthly reports that provide much of this type of information.  You might visit their website and probe the information available.