Mortgage Terms/Conditions - "Not As Simple As Financing Your Home" (For Canadians Only)

In earlier posts, we talked in general terms about Mortgage Financing, and now would like to expand the discussion, as it relates to financing of commercial properties. This is a big topic and we will break it down into smaller parts over the next few posts.

In considering financing - the first decision is whether to work with a Qualified Mortgage Broker or to approach Institutional Lenders directly. In going the Mortgage Broker route, you’ll likely have a better opportunity to source multiple lending sources, since they will shop the market for you. If you approach Institutional Lenders yourself, the obvious benefit is that you are dealing directly with the mortgage originator (decision maker) and the one on one may simplify the process. Either approach can work, depending on not only your own expertise, but the type of property being financed.

Qualifying for commercial mortgages is a fairly rigorous process, and unlike residential mortgages (which often are insured through CMHC), there is no such backstop (protection) for the lender.  As a result, you should assume the following:

·        Designed to protect the institutions against default/losses

·        Generally tougher to qualify for

·        Involve shorter amortizations

·        Structured to guarantee the interest component

·        Involve considerably more upfront soft costs

(ie. appraisal, environmental, structural reports etc.)

Turnaround times on commercial mortgages are often 45-60 days - that is from the time of initial application to receipt of a detailed/written mortgage commitment.  This also assumes that all of the parties conducting all of the reports noted above, are on-time and not delayed for any reason. Certain lenders may also require the posting of a set-up fee at the time of application, to cover their costs to process the mortgage.

Lots more to follow on financing.... as always, seek out the advice of experienced commercial realtors within your market, as you consider mortgaging alternatives on any real estate acquisition.

Purchase Price Allocation - How/When/Importance... (For Canadians Only)

Purchase price allocation of a commercial property, is necessary at the time of sale.  In the case of the the Buyer, they need to allocate the  purchase price to establish their original cost amounts, for the purpose of computing amortization and depreciation. With the Seller, they need to allocate the price to determine their taxable income – primarily with respect to capital gains and recaptured depreciation.  Best practice is that it be negotiated within the Offer to Purchase Agreement itself.

In terms of what’s being allocated in a typical commercial property sale, it should include valuations on the following at a minimum:

·        Building

·        Land

·        Equipment/Chattels

In addition, items such as major property improvements (ie. surfaced parking lots, out-buildings), can be categorized and valued separately. Valuations should be realistic and supportable, as they can certainly be called into question by the TAX MAN at some point later. Clearly this is also an area that requires the involvement of your accountant, to review the future tax consequences of the proposed allocation.

It should also be noted, that the Buyer and Seller will often have opposite positions on the respective valuations – the Buyer wanting to allocate as much as possible to the hard asset side (building/equipment) & the Seller wanting to minimize this portion to reduce capital gains/recapture costs . All the more to reason to ensure it is a term negotiated upfront.

As always seek out the advice of experienced commercial realtors within your market, as you consider the implications of Purchase Price Allocation on any Purchase/Sale.

Repairs and Replacement of Major Capital Items - Who Pays?

Who pays and is responsible, for repairs to major capital items, when they arise?  As the acquirer of any investment property, you should closely review all existing lease agreements to ensure you understand what the financial implications are to you, as the prospective landlord.

Full net leases typically allow the Landlord to assess the entire obligation for the repair, on to the Tenant. So in the event of a $1000 repair bill on a rooftop HVAC unit, it can be added to the Operating Cost Recovery for the property and results in a flow through charge back to the Tenant. Assuming it’s annualized, it effectively changes the Tenant’s regular operating cost by about $83 per month.

But in the event of a major replacement (ie. $10,000 to replace an HVAC unit), how does the “LEASE READ”?  More importantly how is this cost recovered from the Tenant and over what time frame?  Due at the time of replacement, within 12 months, or amortized over 5 -10 years...all may be possible, depending on how the ‘Repair & Maintenance Provisions’ are written in the lease.

As a prospective owner, funding major repairs and outright replacements of ‘big ticket’ capital items is an area you need to seriously account for.  Parking lots, roofs, and mechanical equipment are all significant cost items. Most often if they are 100% recoverable, it is likely only on an amortized basis and over a period of years.

In order to have a complete understanding of the maintenance and repair obligations, AND THE FINANCIAL BURDENS THEY POTENTIALLY INVOLVE, the maintenance and repair sections of the lease must be carefully reviewed in conjunction with the lease provisions dealing with operating cost recoveries.

This is again a case of completing sound DUE DILIGENCE with respect to the leases in place on the property. As always seek out the advice of experienced commercial realtors within your market and as you review the implications of ‘Repairs & Replacement' on investment properties being considered.

Investment Property Insurance - How Important?

As is the case for insurance on your own personal residence, properly insuring your investment property is extremely important.  Protecting this asset with proper coverage is essential and helps ensure your overall investment strategy, doesn’t evaporate through an unforeseen event.

Building insurance generally covers total or partial building loss as to an agreed upon policy amount. Coverage should be sufficient to cover any damage based on relevant estimates of current replacement costs – ie. if $125/ ft. is the current figure to replace a commercial building in the event of a total loss, then that’s the level of coverage you need to have in place.  If you choose to ‘under insure’ by taking out insufficient coverage, you are in reality ‘co-insuring’ the property. In this case, you will be responsible to pay any amounts above and beyond what the insurance coverage provides for.

Landlord’s insurance generally covers loss of income and tenant damage.  Loss of income would be coverage if a property was unfit for rental purposes for a period of time. With respect to Tenant damage issues, it could cover default by the tenant due to vandalism, theft or malicious acts.

There are certainly other specific coverages that you may need for your specific purposes – ie. accidental plate glass breakage, power failures/surges, sewage back-up, to name a few.

Best practice here, is to review your requirements with your commercial insurance broker, making sure you have a comprehensive analysis done on your specific property.  As always, seek out the advice of experienced commercial realtors within your market, as you review your property insurance options.

Property Taxes - About Assessments & Tax Rates (Ontario, Canada Only)

Municipal tax costs on any commercial property are generally significant and a major annual expense.  The tax bill is basically a bi-product of 2 factors:

1. The Current Value Assessment (CVA) of the property

2. The Municipal Tax Rate

Assessments are provided by the Province of Ontario (thru MPAC) and the tax rates are then levied by the local municipality. The Net Tax owing is then determined through a process of straight multiplication. Since the Tax Rate is set by the municipality, it is a part of the formula which for these purposes, I would suggest you have little/or no influence on.  However, you do need to keep an eye on the CVA side, to ensure it is realistic and relevant to the property’s Current Market Value.

With that in mind, there are three specific methods of valuation

1. Income Approach 

2. Comparative Sales Analysis 

3. Cost Approach 

The first 2 are most often used, with the Cost Approach used primarily in cases where there is a lack of data available, for purposes of a proper evaluation/comparison.

In considering the above, it is always a worthwhile exercise to determine how realistic a property’s CVA is, ensuring you are not paying more than your fair share on property taxes. If your analysis determines that the assessment is overstated by 10-20-30%, by all means file an appeal through MPAC. Bear in mind, there are rules and regulations to follow in filing an appeal, and it can be arduously slow - but you can successfully reduce your assessment if the facts clearly support your position (meaning the CVA is overstated).

Just a final note, there are full time tax assessment consultants throughout the province, who specialize in reviewing property assessments and handling appeals.  Absolutely worth at least a discussion, to see how they might be of service.  Also, MPAC is very approachable on matters regarding assessments and their website is an excellent starting point.

As always, seek out the advice of experienced commercial realtors within your market, as you review tax assessment matters on specific investment properties.

Property Management - Self Managing

The concept of ‘self managing’ a commercial property may make sense in certain situations.  If you have the ability and resources to provide the necessary services for the property, there is no reason you shouldn’t consider managing the property on your own - and pay yourself to do so.

What might this look like and are there issues that need to be addressed?  As with professional management, it needs to include the first 3 elements – Asset Management (AM), Financial Management (FM), and Physical Maintenance.  Since you are the owner,  the AM/FM component becomes more of an internal exercise, as you are basically accounting (reporting) to yourself.  Tenant communication is probably the biggest key, and you should attempt to provide it a level which is comparable to professional management. That doesn’t mean it needs to be overly complicated and detailed – but rather efficient, clear, and easily understandable. On the leasing function, you may opt to involve a real estate brokerage to handle new leasing placements.  In this scenario, you might retain the responsibility of negotiating any new deals, lease preparation, and completing any work required to deliver the space.

Bear in mind, you are wearing a lot of hats in self-managing. You need to do a good self assessment to ensure you are up for the task.  In preparation, consult with your professional advisors (lawyer, accountant, & of course r/e broker) to make sure you are able to deliver the service needed on all counts.

Should you pay yourself – ABSOLUTELY!  There is no such thing as 'Free Management’ and it should be costed at levels consistent with whatever is typical in your market. If done properly, it is often a  ’win-win’ for owners and tenants, given the vested interest both have in the property.

Again, seek out experienced commercial realtors within your  market to discuss prospects on ‘self-managing’ your property. 

Property Management - Who Pays? Where is the cost shown?

A couple more good questions – and the simple answer is, it depends on the type of lease agreement(s) in place on the property.  Are we dealing with net lease agreements, whereby the tenant pays all operating costs associated with the property (TMI). Or are they gross or semi-gross lease agreements, where the tenant pays a set/specified amount irrespective of the operating costs associated with the property. If you are not sure, take a close look at the lease agreement(s), to determine the exact type of lease that is in place.  

In the case of a true net lease agreement, the tenant typically pays the cost of the property management through an additional rent charge – commonly known as TMI (taxes, management/maintenance, insurance). Management is clearly reflected in this ‘acronym’, and the associated cost forms part of the additional rent.

In the case of a gross lease agreement, the landlord typically pays the cost of the property management out of the total gross rental(s) received. It may or may not be adequately covered for in the gross revenue figures – but it must be accounted for, when you determine the true net income figures.

You may encounter a variety of hybrid leases within your market – ie. customized in between a true net lease and a true gross lease – but in the end, you need to determine how the lease(s) provides for management expense and who is ultimately paying. 

A few final caveats in this area –

·        Ensure statements provided are consistent the leases in place

·        Net Lease Tenants can challenge non-competitive management costs

·        Lending Institutions will apply their own management cost factor (which may be inconsistent with costs provided with the property)   

As always seek out the advice of experienced commercial realtors within your

market, as you analyze the relevant management costs associated with the

property investments you are considering.