With banks not lending on commercial property as they once were, seller financing is becoming the alternative for conventional loans. Here, I am defining commercial property to mean multi family, shopping centers, office buildings, industrial sites, mobile home parks, and hotels/motels. Whether you want to sell your commercial note to a Note Buyer, or keep your note for cash flow, there are certain parameters that should guide your decision whether or not to owner finance. The same goes for the investor who wants to purchase commercial property. Remember, if the property cannot pay for the debt service, you definitely do not want to purchase the property, and unless you, as the seller, want the property back, you should think long and hard about seller financing, or possible restructuring of the note, if the property's cash flow cannot service the debt.

In this issue of THE NOTE PROFESSOR NEWSLETTER I am not going to have time nor space to go over NOI (Net Operating Income, which is critical to purchasing commercial property), cap rates, cash on cash formulas, or other financial indicators of the profitability of commercial property, Rather, I am going to revisit the importance DSCR, (Debt Service Coverage Ratio) for not only creating a commercial note to sell to a Note Buyer, but also prudent structuring a seller financed note to increase the odds of not having a foreclosure. While investors and accountants look at the NOI as an indicator of profits, lenders look at the NOI as "funds available to service debt". This is where the DSCR comes to play. The DSCR is defined as NOI divided by the debt service. This measures the ability of a property's cash flow to pay for the debt service. A healthy DSCR is 1.25, which is a barometer of what many lenders require to obtain conventional financing. The closer you get to a DSCR of 1.00, which is break even, the more likely the possibility of the property having to go into foreclosure. (I have seen commercial notes with a DSCR below 1.00. DANGER, WILL ROBINSON, DANGER)

Often the DSCR can be brought into acceptable parameters by requiring your buyer put more money down. (Remember, only under rare circumstances can a property cash flow with less than 20% down) A case in point was an estate which had an 8 unit for sale. The apartment was free and clear, and the heirs were eager to rid themselves of the property. They had an offer of 10% down, and the estate would take back a note. The heirs contacted me to inquire how much a Note Buyer would pay for the note as it was structured. My preliminary analysis indicated the DSCR would be 1.10. This is a foreclosure in embryo, which makes the note unmarketable. The reason the note is unmarketable is because WHEN, not if, a major repair is needed, the cash flow will not be able to fund it. Deferred maintenance leads to loss of tenants, which results in loss of income, which results in foreclosure. It is that simple.

Without getting into other issues, like the cap rate was equal to the interest rate (A BIG NO NO. In my opinion the property was a little overpriced), I suggested if the buyer were to put 20% down, and they lower their interest rate a tad, (a "tad" is a little more than a "smidgen") the DSCR would be increased from 1.10 to 1.30. These changes would have the effect of not only making the note marketable to Note Buyers, but would also give the buyer a cushion for performing routine maintenance.

I bring up DSCR because this is one of the major tools banks use in determining if and how much the banks will lend on the property. Banks do not care how much the property sold for, but rather the ability of the property's cash flow to pay for debt service. As a seller of commercial property, you should have the same criteria. (In fact, many institutions will use "Net Cash Flow" to determine the DSCR. Knowing this will sometimes get you the loan)

In summary, whether you are purchasing or selling multi units or shopping centers using seller financing, the DSCR is a primary factor in determining if the deal makes sense. If it does not make sense, DO NOT DO IT!!!!

Hope this helps.

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if you have a topic you want me to discuss. It is from your feed back that I get my topics. I look forward to hearing from you.

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One of my subscribers and friend sent me an article from a well known investment newsletter. In this article, there is a major flaw in the author's premise that is prevalent in today's "main stream" economic thought. The article began: "Financial panics are an integral part of capitalism. So are economic recessions". You would think a contributor to a major investment letter would know better than to make such a fallacious assertion. This major flaw in economic law leads to miscalculations from not only political central planners, but also many investment advisors, CEOs, and the public at large. A case in point is this weekend I heard on a financial network one of the "experts" state something to the affect, "we are just in a down slope of a "natural" business cycle, and all we need to do is ride it out".

With this type of sentiment being portrayed, it is time we revisit the cause of boom/bust cycles. To begin, business cycles are not inherent in a free market system, nor are business cycles a "natural event". In fact, just the opposite is true. Business cycles are a man made phenomenon, which are a result of a lousy monetary policy of fractional reserve banking, whereby central planners can expand and inflate the money supply by creating money out of thin air, as well as setting the price of money (interest rates) artificially low. By setting interest rates artificially low and expanding credit, lenders will lend, and borrowers will borrow, not because it makes good business sense, but only because money is cheap. As a result, a bubble will form in some form or another.

The current real estate bubble is a prime example. Because of "easy money policy" of the Federal Reserve, mortgages were readily available to anyone and everyone who applied for a loan. Since the price of real estate is directly proportional to the financing available, the laws of supply and demand dictated the price of real estate will necessarily rise because easy money artificially increased the demand for real estate. Like all boom/bust cycles, at first the "easy money" policies gave the illusion of prosperity. It was not long ago that builders were profiting, rehabbers were profiting, real estate investors with no money were profiting, hard money lenders were profiting, individual home owners with little or no money down were profiting, Realtors and title companies were profiting, not to mention mortgage brokers, mortgage companies, hedge funds and banks, lumber yards, plumbing suppliers, along with all industries connected to real estate. Anyone who mentioned this is all an illusion and is destined to crash were called "dooms dayers", or my favorite, "it is only theory". Nobody wanted to face the fact this was all a fantasy.

But alas, the never ending rise in the real estate market was only an illusion. A bubble had formed. When bubbles form, bubbles will also burst. The price of real estate got to the point where the market told us, "NO MORE". The result was real estate prices started to decline and decline fast. We are still witnessing the result of this bubble. Was this bubble, or recession, "natural" or "an integral part of capitalism"? NO! It was triggered by central planners arbitrarily setting the price of money well below market value. Interest rates serve a function in any economic system. Interest rates are a language to economy telling us the demand for money is exceeding the supply. However, interest rates were not allowed to seek their natural level. They were set artificially low. The artificially low rates distorted the market.

Had interest rates been allowed to seek market level, instead of being set artificially low, many buyers would not have been able to afford mortgage payments going out the gate. This would have the affect of keeping real estate prices at a true market level, rather than rising out of control. It would also have prevented the hedge funds from borrowing short term and lending long term. Is it becoming clear that recessions are not natural, but rather a man made phenomenon? As usual, the press and politicians look for scape goats and villains, while ignoring the economic laws of supply and demand that triggers recessions. Because of easy money policy of the Federal Reserve, which started in 2001, the price system for real estate was distorted by "cheap and easy money" artificially increasing the demand for real estate. It should be noted if the bubble had not formed in real estate, it would have formed somewhere else. For example, in the 90s it was the "Dot Com Recession", in the 80s it was oil. However, this time the bubble formed in real estate. To add to the "perfect storm", government put pressure on institutions to loan money to those not credit worthy, and then "the overseers" turned their head when Fannie Mae started buying all these toxic loans. Is this a "natural phenomenon" or man made? Is the Federal Reserve's setting interest rates artificially low an "integral part of capitalism", or man made? (BTW, in a free market economy, a central bank nor Fannie Mae would even exist, much less political "overseers")

As a side note, unlike past recessions where we have merely produced our way out of it, this down turn is much more serious. Why? Because we have reached the point where governments are consuming more than the ability of producers to produce(going into debt). This is true not only in America, but world wide. What we are witnessing in Greece, Spain and Europe is what is in store for America. The fact is organizing economies based on collectivism is unsustainable. The collectivist systems, world wide, are collapsing. Is it becoming clear that recessions worldwide are man made, and not a "natural" business cycle, nor an "integral part of capitalism"?

In summary, business cycles are NOT inherent in free markets, nor a natural phenomenon of capitalism, but rather the result of man made errors in trying to control the supply and price of money. Central planners' arbitrarily setting interest rates artificially low, and increasing the supply and availability of money, boom/bust cycles are created. We are in the bust cycle, or recession, where the bubble was created in real estate this time around. So whenever you hear free markets is the cause of recessions, or boom/bust cycles are inherent in free markets, remember, all cycles are cause and effect. The business cycle is no different. The Cause: Manipulating the cost and supply of money -- The Effect: Boom/Bust Cycles.

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