Why should you use debt instead of paying cash when purchasing a property?

• Excess funds can be used to purchase other properties, spreading investment risk over several properties.
• The mortgage payments are tax deductible.
• Generally, you can borrow money at a rate of interest that is lower than the expected rate of return on total funds invested in the property - thus leveraging your money.

There are several formulae which we can use to determine actual before- and after-tax rates of leverage. We don't need to worry about them much. The simple approach is to make sure that the after-tax rate of return on the investment exceeds the interest rate of the debt.

Debt Structure

Lenders generally want an income property loan to be structured such that the income from the property is more than sufficient to cover the mortgage payments. This is done by requiring the Debt Coverage Ratio (DCR) to be greater than some number, generally 1.2. Of course, the borrower wants the highest Loan To Value (LTV) ratio to maximize his leverage. How to resolve this basic conflict of desires?

Keep in mind several facts:

• The income from the property should increase over time
• The value of the property will increase over time
• The equity also will increase over time

While conventional fixed payment loans are common, they do not address the needs of the banker and investor, considering these facts. There are several loan structures which do, including participation loans, interest-only loans, accrual loans and sale-leaseback of land. Be advised, however, that your banker may not be terribly excited about making these non-standard types of loans. There are financiers who are familiar with income property purchases and may be more accommodating - please visit the Resources page for links to some of these organizations.

Wrap-around Mortgage

This is an alternative to simple financing from the bank. The seller keeps his existing loan and at the same time makes another loan to a buyer:

This might be useful when:

• Interest rates on the existing loan are below current market rates
• There is no prepayment option on the existing loan
• Buyer wants put less down payment on the purchase

...but this option can be defeated with a "Due on Sale" clause in the loan provisions.

Return on investment is the goal of investment real estate. When considering the purchase of an investment, the major factors contributing to return are the purchase price, net operating income (NOI), and perhaps most importantly, financing. Even before making an offer, involving your banker is critical to the cash flow analysis. Availability of financing and the proposed terms of the underlying financing represent a critical portion of the return on investment analysis and the decision process. Surprisingly, initial underwriting often uncovers issues that may not have been considered otherwise. Those issues at times have a material impact on your decision-making process.

Choosing your investment banker is an important step. While it may at first seem more convenien to use your current banker, he or she may often be constrained by internal guidelines, and the terms offered may not create the optimum ROE. Using a banker specializing in commercial real estate will often pay dividends, not only in competitive loan terms, but also in creative solutions to difficult or unusual situations.

For your commercial real estate financing needs, please call Scott Wolfe at (303)758-5515. Scott specializes in long-term fixed-rate loans for income-producing properties. He also provides commercial mortgages for purchase, refinance, and A&D and construction lending. Please visit his website at www.wolfefinancial.net.