Q: If loans to owners are subtracted from cash flow, why aren’t loans from owners added back to cash flow?

A: Loans to owners and loans from owners play very different roles in the cash flow dynamics of a company. Loans to owners are basically a form of compensation to the owner, and there is generally no intent to repay the loan on the part of the owner. These loans are frequently converted to distributions or withdrawals and become permanent cash outflows. Loans from owners, on the other hand, represent financing often made as a “last resort” when the company is unable to secure necessary third party financing. A loan from the owner is made with the full intent of being repaid as quickly as possible.

In summary, we focus on cash available to service interest-bearing debt after accounting for all operating expenses, which includes loans to owners since there are characterized as compensation. Loans from owners are classified quite differently since they serve a very different purpose, which is to provide financing in the event of a cash flow shortfall.

Q: These DSCRs assume that every year Mr. Schumacher intends to borrow $918,000 from one of his properties, and that isn't likely to be sustainable. If we argued that loan was a one-time loan for a specific purpose, is it reasonable to add that back into our calculations for servicing debt next year?

A: We always need to estimate recurring cash flow to the owner/guarantor. In this instance, we need to determine if the Schumacher group of companies could continue to provide cash to Schumacher in these amounts.

Given these circumstances, we would no doubt require and analyze projections with valid assumptions for the next year before we would consider going forward with this relationship.

But key point is that personal cash flow is a very poor indicator of cash support, and we need to always look to ready cash of the guarantor on his or her balance sheet and not to personal cash flow to determine likely cash support in a crisis.

Q: You mentioned in your webinar that an Appraisal should not be used when determining the value of the collateral. Can you please explain why?

A: We stress the point that the market value of an appraisal should not be taken at face value, but, rather, examined and tested by the lender to determine if it appears realistic.

Appraisals are generally performed under the assumption of market equilibrium, i.e., under the assumption of stabilized market conditions in which there is no pressure for rental rates, vacancy rates, and operating expenses to move up or down.  As a result, the assumptions about rental rates, vacancy rates, and operating expenses used by the appraiser may differ greatly from existing rental rates, vacancy rates, and operating expenses for the property in question, which means that the "stabilized" net operating income (stabilized NOI) may be significantly greater than existing NOI.  Consequently, the resulting estimate of market value using stabilized NOI can be materially greater than an estimate of market value using existing NOI.  

In addition, any estimate of market value is, at best, a very rough guess at market value in liquidation circumstances.  The lender does not know when it may be compelled to take over the property in the event of default and liquidate the asset.  Because no one can predict the timing of an event of default, no one can accurately predict the market conditions that will prevail at that time and, hence, no one can predict the cash liquidation value of the property (collateral).  

We emphasize, in assessing any real estate transaction, that existing NOI is the critical issue.  Existing NOI pays interest expense and repays debt as scheduled.  The lender's primary task, in our opinion, is to determine if existing NOI - not stabilized NOI in an appraisal report - is sufficient to meet proposed debt service.

In addition, keep in mind that the primary and preferred source of debt service is NOI.  The liquidation value of collateral is the last way out of a deal.  Since we cannot predict when a default will occur and since we cannot predict the cash liquidation value of the collateral at the point of default, we are compelled to apply all of our expertise in estimating if existing NOI is sufficient to service debt on the proposed transaction.

Having said this, if the lender tests the appraisal assumptions and finds that they do agree with existing market conditions and, in addition, is satisfied with the cap rate used by the appraiser to convert NOI to an estimated market value for the property, then the lender can be comfortable with the appraiser's estimate of market value.  Even so, the uncertainties still exist about the cash liquidation value of the collateral at the point of default, if and when such an event occurs

I should mention, too, that we address this issues in considerable detail in our Credit College Course on CRE Loan Underwriting.