The Three Pillars of Commercial Real Estate

I have written numerous times on using the right tool for the right job. In this article, I want to focus on what that looks like in the realm of commercial real estate.

The creditworthiness of commercial real estate rests upon three pillars: rental cash flow, loan-to-value and the sponsors. Knowing this, you put away several of your credit analysis tools immediately. Put away your liquidity tools, put away your leverage tools, put away your UCA cash flow, and put away all your tools for analyzing receivables, payables, and inventory.

To assess cash flow, you need to concern yourself with two things: 1) What type of real estate are we dealing with, and 2) What is going on with market rents?

Different real estate types have different expense structures. Office, retail, and industrial real estate have relatively low expense because the tenants are expected to pay for most things, including maintenance, taxes and insurance. Residential rental real estate has moderate levels of expenses, since they are typically shared between the owners and renters. And special purpose properties, such as hotels, have high expense ratios since the owner is expected to pay for virtually everything.

Understanding rental markets is also key, because the demand for each real estate type is different. In this case, market reports are your best friend. Use a market report to establish what the market rate rent is for your piece of real estate. Then apply the appropriate cost structure, and see if there is enough pro-forma income left over to meet debt service payments. If there is, then you have one of your pillars in place!

Next, we have to concern ourselves with loan-to-value. This measure is unique, because it simultaneously tells us about our collateral position, as well as the equity in the transaction. As a rule of thumb, the riskier the real estate type, the more equity we want to see in the property. In other words, special purpose properties will have low loan-to-values, more marketable office and retail will have moderate loan-to-value ratios, and very marketable residential real estate will have high loan-to-value ratios.

Lastly, we look at the existing or proposed owners or principal operator. Generally, whoever will be responsible for overseeing repayment, we call them the sponsor. We assess their willingness and ability to repay, as well as their experience with real estate type. Willingness and ability to repay the loan matters, because if a tenant vacates the real estate, the sponsor may need to pay the loan for some time from their personal account until a new tenant can be identified. Experience matters, because that tells us how good they are at keeping paying tenants and how much they reinvest in necessary maintenance.

And that is how you underwrite commercial real estate, in a nut shell. When people start pursuing other items and measurements, they may find themselves lost in tall weeds. What people tend to focus on the least is usually what matters the most: local market conditions. The demand for a specific real estate type will affect what can be charged for rent (cash flow), which drives its value (loan-to-value ratio), and ultimately, affects the sponsor if he or she has similar investments in this type of real estate.