Understanding Debt Service: Finding Real Liquidity Through your Property

By Marcelo Bermúdez, President, Figueroa Capital Group, a subsidiary of Charles Dunn Co.

A property's ability to pay for its debt is paramount to any lender. While an asset's appraisal may give the impression of a good investment for a lender, the debt-service ratio can be another useful metric to consider.

By Marcelo Bermúdez,
President, Figueroa Capital Group, a subsidiary of Charles Dunn Co.

I was recently given a referral to a broker who had been in the industry for a respectable period of time and had a decent portfolio of clients. His client wished to pull out more than $3 million in cash on a retail property located in a major MSA in Los Angeles with no anchor tenants and a 40 percent expected roll-over of leases in the next 14 months. The property was free and clear and was the only property they owned aside from their primary residence. The purpose of the cash-out had no real plan other than to have cash on hand for potential purchases.

The property would likely have appraised for more than $4.5 million because of its location, but the debt service — net operating income divided by annual debt service — was telling another story. Rents had been flat for the last five years and there had been a revolving door of tenants for some of the smaller spaces, including a failed marijuana dispensary that had come under the watchful eye of the local authorities and later shut down voluntarily by the operator. On a good day, the property might have been able to carry about $2.2 million in debt. Because debt service is a ratio, anything below 1.0 signals an operating loss and an inability to service the debt. Most banks are hovering in the 1.25-1.40 range to get a transaction done and consider quite a few other factors to get to an offering. The borrower did not have much of a relationship with their home bank and they offered the borrower $1.5 million for a 3- or 5-year term using an attractive 1-year LIBOR floating rate and were requesting a detailed explanation as to where the money was going. The borrower had come to me very frustrated declaring this was a homerun since it was only a 50 percent loan-to-value transaction and that any bank should want to do it with their eyes closed. Where is the disconnect?

A property’s ability to pay for its debt is paramount to any lender. While this may seem remedial, borrowers tend to forget what actually goes into figuring out net operating income. For efficient owners, they might be managing their own property keeping those fees for themselves and likely don’t put money aside for replacement reserves since no one is forcing them to do so. Banks are adding those fees back in because they’ll need to understand how the property will operate if they need to foreclose. Vacancies and credit losses are also a factor that will be put into assessing the NOI. What the borrower’s books might say won’t look like anything the underwriter at a bank will come up with when preparing a letter of interest. Vacancy and expected roll-over also help determine the type of term a bank will be comfortable offering. They don’t want to send a letter to their borrower in a year saying their loan is being re-margined.

If you know 40 percent of your tenant base is potentially leaving in a year, it’s best to get your real estate broker on the phone and have him or her start a campaign to look at what renewals will look like. Large amounts of cash-out that aren’t paying off other debts or that have a direct plan in place to acquire assets in play are also non-starters for lenders. You will see a good amount of push back even if the borrower’s personal balance sheet is healthy when using a global debt service approach. While banks are quietly raising leverage to make deals work, it is best to have someone underwrite your transaction to manage your expectations and understand where the lenders might come in to help you in your strategy to get your property to provide you the liquidity you will need in the near future.