|
|
How To Underwrite Mixed Use: Examining A Downtown
Case Study
In an example file, a downtown retail property creates underwriting questions.
Ultimately, pricing the deal at the underwriter’s discretion.
BY JOHN C. HWANG
Mixed use properties, also known as multiple use properties, are probably
the second most popular commercial property type behind multifamily. By
definition, a mixed use property contains more than one property type.
So, how do lenders underwrite these loans?
When reviewing a loan request for a mixed use property, lenders have to
first identify the following:
- uses of the property,
- income stream generated by each property type,
- square footage occupied by each property type,
- the highest and best use of the subject property,
- the alternative use of the subject property,
- the demand and supply in the current market.
These general guidelines will help lenders to develop the appropriate
underwriting and pricing guidelines for this particular loan request.
When mentioning mixed use properties, most people automatically refer
to smaller properties in older neighborhoods, i.e. a small grocery store
on the ground floor with apartments upstairs. This scenario, indeed, is
the most popular stereotype of a mixed use property. You do see a lot
of these buildings along the East Coast in states such as New York, New
Jersey, Pennsylvania, Maryland, Virginia, etc.
Nowadays, however, you will also find the more modern types of mixed use
combinations such as office/retail, office/industrial, hospitality/retail,
etc. in much newer neighborhoods.
These properties were developed along with the changes of the neighborhoods’
demographics. For instance, a new campus may create the demand for office
and warehouse facilities. With a sufficient number of the employees there,
retail components may also be required. Then, there’s housing demand.
Once you have identified the property types involved, you then need to
decide how to underwrite them, or, more importantly, how to price the
deal.
A two-pronged test
At this stage, lenders normally use a two-prong test:
- which property type represents the majority of the income stream?
- which property type occupies more space in the building? The
general rule of thumb is the 60/40 guideline.
At this point, I would like to use one of the files we financed as an
example to illustrate items two to six. This particular case involved
a bank headquarters in a downtown retail district in New York.
This particular building contained four stories and a basement. The bank
occupied the entire building, and there were no other tenants involved.
This created even more problems when we underwrote the file. A single
tenant in a strong downtown retail district. How do we approach it?
Since it was a single-tenant property, we went straight to the highest
and best use of the subject property (item four). After a visit to the
site and the neighborhood, we determined that the highest and best use
of the subject property was office for the upper floors and retail with
a basement for the ground floor.
Based on the building layout, the upper floors could be easily converted
to a multi-tenant office, while retail was still the highest and best
use of the property on the ground floor (item five).
Due to local zoning restriction, the upper floors could not be permitted
for residential use. So, the highest and best use of the property and
the alternative use of the property was office for the upper floors and
retail for the ground floor and basement.
Potential income from the property
The next step we took in underwriting this file was to determine the potential
income from the property. Before we could do that, we needed to determine
the current market inventory for each property type and the demand/supply
ratio (item six).
After making a few phone calls to the local Realtors and appraisers and
examining our marketing survey, we concluded that there was no excess
land in the neighborhood for future developments, except to tear down
existing buildings.
The demographic survey indicated a 8.6% increase each year, while the
supply of new buildings remained constant. There was a considerable shortage
of office and retail properties in the immediate neighborhood, and the
ongoing rent escalation was among the highest in the region. This concludes
the first phase of the underwriting process.
The second phase of the underwriting process was to determine if the current
cash flow generated from the property is comparable to the market rent.
Remember that the subject property was occupied by a single tenant under
a long-term NNN lease. Therefore, some might ask, “why can’t
we treat it as a single-tenant property?”
We could, but what happens when the bank moves out? In the event the tenant
decides to vacate the premises prior to the expiration of the lease term,
the owner of the property would want to fill the vacancy as soon as he
can.
If the owner cannot find another bank to replace the outgoing tenant,
he would have to face reality and consider the market demand, which is
office and retail. The same dilemma can happen to the lender if the loan
goes into default and the tenant moves out.
Assuming the upper floors will be converted into multi-tenant offices
and the ground floor will be rented to a retail tenant, two things will
need to be determined:
- the income ratio between these two components, and
- the occupancy ratio between these two components (items two and
three).
The pricing policy
This exercise will lead to the pricing policy. After consulting with our
engineer, we have determined that, based on net rentable square footage
(NRSF), the occupancy ratio between the two components is too close to
call, so we have to look into the income ratio.
The appraisal survey indicated that the income generated from the office
component is almost equal to the retail component. Now what? Realistically,
it is the underwriter’s discretion, at this point, to price the loan
either as an office or retail.
A good underwriter will price a loan that will meet the lender’s
overall yield earning requirement and at the same time, will satisfy the
borrower’s rate requirement. Most importantly, the underwriter must
write the loan that leaves enough cushion for the worst-case scenario
so the loan will not be challenged when securitized.
During the pricing process, we did some more checking with our appraiser
and were informed that the current zoning regulation was soon to be modified
to lift the existing building height restriction. (It did happen 12 months
after the loan was closed.)
As a result, the subject property may potentially add a few more floors
on top of the existing structure. That means, we will have more office
than retail on the subject property. Although unanchored retail pricing
would give us a better yield than the office pricing, pricing this loan
as an office building put us in a better position than other lenders we
were competing against at that time.
The underwriter’s discretion
Again, it’s the underwriter’s discretion, and he decided that
we are better off making a little less on the yield and getting the loan
than pricing it high and risking losing the deal. So, office price it
was.
Once the property types are identified and pricing is determined, the
rest is easy. The typical guideline for vacancy and collection loss for
office and unanchored retail ranges from 5% to 12% or market, whichever
is greater. There is always a management fee ranging from 4% to 5% or
market, whichever is greater.
For commercial property types other than multifamily properties, a lender
must also consider the capital improvement and leasing commission expenses.
A structure reserve ranging from 10 cents to 25 cents per square foot
is typical in underwriting this type of property.
In addition, a lender must also calculate the overall expense ratio and
ensure that the property’s operating expenses are within reasonable
market range. Typical expense ratios for this type of property generally
range from 40% to 50% or higher, depending on the market.
Bear in mind that when reviewing the income stream generated from the
subject property, you may want to find out first if the rents were at
market. If the rents were higher than the market rent, a lender will generally
mark down the rent to market.
The same principle applies to expense ratio. If the expense ratio was
lower than the market, a lender will generally mark it up to the market.
Since conduit lending is restricted by the rating agencies’ guidelines,
the underwritten result for the same loan should not vary much, regardless
of who the underwriter is. Know your deal.
John C. Hwang is managing director at H&A Capital in Massillon, Ohio.
He can be reached at (330) 834-1681.
This article was previously published in the April 2001 Issue of Commercial
Mortgage Insight
|
