Real Deal REInvestor Network

Tenants as Partners
Now you’ve learned how a stable an investment when the seller becomes a partner in your commercial property deal. Tenants are the next best kind of investor to have, because they help qualify the deal due to owner-occupant status which reduces the vacancy risk.
When tenants become your partners, they have a vested interest in the property. They’re not as likely to move, because they have a stake in the deal and risk that stake if they move out.
For instance, suppose you have a tenant in your property for half the space, and he’s a 50% owner in the deal. You can go to the bank and show them that your Pro Forma projects a 3.5% vacancy.  Even if the ordinary vacancy rate for that area is 7%, they’ll quickly see this as a viable deal.
Dealing with a tenant, rather than a partner, may mean that you must raise more money.
However, very often that isn’t true, because with a tenant you can qualify for a higher loan- to-value.

Contractors as Partners
Some deals involve a tenant and a construction company. You might be able to form a deal without putting in any money at all. When renovation is involved, it’s handy to have a construction company partner to immediately take care of those issues.
If you hit the real estate cycle at a time when there’s not a lot of construction going on, you can more easily find and negotiate with construction companies. They may be hard pressed to find whatever jobs they can, so that they don’t have to lay off their key workers.
Tip: If you don’t have any construction background, be sure to get at least three bids on your jobs.

Financing the Property    
This 70% loan loan-to to-value deal should be very easy to finance. For one thing, one of the signers on the loan has owned the property for 15 years and has a great payment record.
To make the cash flow work, start with the Gross Operating Income of $720,000. Then subtract the annual debt, which is the mortgage payment: $4.2 million x 7% for 25 years x 12 = $356,260. NOI is $500,000, which you divide by $356,260 for a total of 1.4 Debt Coverage Ratio.
The Debt Coverage Ratio indicates what kind of a cushion the borrower has in the deal. If you have an NOl of $500,000 and you’re only paying $350,000 in debt service, you have about a 40% cushion. Most banks want 1.2 ratio, but you’re giving them 1 .4 ratio.
Their conforming loans are between 75 and 80%. Since you’re giving them a 70% loan-to-value, the bank should agree to the loan without question. After you’re finished paying on this loan, you’ll have $143,000 in cash, half of which is yours.
As to the owner, he dramatically reduced the amount of his cash flow but he still has that $1.7 million in his hand, and if the property was resold 10 years from now, it is likely to bring $10 million to $12 million.
LLC Partnership
One of the best features of an LLC, and why it’s so popular today, is that you can structure create an LLC within an LLC, which is an IRS-recognized structure. It’s usually recognized in any state you’re in as a type of a corporation, but the IRS recognizes it as a partnership, which is why you can make contributions to it that are not taxable.
Another feature of an LLC is that you and your partners can reallocate the benefits periodically.
You can set this up in the very beginning or by unanimous consent. As you go along, you can change the benefits, one to the other.
Changing the Deal
Consider the scenario where the owner changes his mind and decides that he’s not going to give you half the cash flow in this deal, which amounts to $143,000 in cash.
You can make an agreement with him wherein he acquires half the stock, and until he’s gotten back the $1.7 million left in the deal, ‘you’ll only take a quarter of the income. So, it will take about 17 years before you get anything more than 25% of the cash flow, but you still own half the property.
Therefore, if five years from now, you sell the property for $9,000,000, he the owner will get back his $1,700,000.  first on that 75-25 basis. The remainder will be split 50-50.
So, don’t consider it an obstacle if he insists on having a bigger portion of the deal. If you get a quarter of the income now, you can equalize the deal when the property is sold.
First-Out Situations
First, he will get his $1.7 million back. Next, you’ll count all the payments he’s received so far and subtract that from the $1 .7 million. Then if he’s already gotten back $200,000 in dividends, you only owe him $1 .5 million on this 75-25 split.  Anything above this, you split 50-50.
Even if you have to take less of the cash flow, always make yourself a 50% partner in the deal, so that at the end, you get your half of the profit. Ultimately, he gets his original equity back and you split the “monopoly money.”
This is called a “First-Out” situation. Investors receive their money first and you obtain yours second. Most people are used to this type of accounting when financing commercial deals.
Tip: Income property doesn’t appreciate as fast as residential, which is part of the reason you can buy commercial property proportionately cheaper than you can buy houses.

Closing a Large Office Complex Deal- Part 2
The next step for the two of you is to go to the bank and sign off on the deal. Even though you have an LLC, you should sign personally because the bank already has the property as collateral and they are more interested in the cash flow. That’s two of the C’s— all that’s missing is the credit, but this property doesn’t have any, so what they want is the credit of the people who own it.
Even if your FICO of 500 they aren’t going to refuse this deal because you have a partner with $3,500,000 of equity in the deal, who is going to sign personally.
That is one less obstacle, because the bank is going to view this as a viable deal. Your partner has real equity in the property, so they can use that for his down payment and they don’t care where the money comes from—they don’t even mind that it comes out of the equity of this property, because it conforms to the laws of their auditors.
Getting the seller to be your partner is the best form of financing there is. The seller has a substantial amount of money, has had this business for some time, and has some real motivation to execute this deal. Therefore, he is a prime candidate for this type of arrangement.
The “You and Me LLC” will buy the property for $6 million. Then, the owner leaves and takes out a big chunk of cash, meaning $3.5 million, of which he contributes half to the You and Me LLC. Then, he takes $1,700,000 out of the deal in cash, but you still own half the property.
Your partner now has a safe, profitable investment with which he feels very comfortable—it’s a built-in reinvestment plan. One of his biggest benefits is tax-wise—he now has half the capital gains on which to pay taxes, had he sold the property without reinvesting.
If he took $3.5 million out of this property, he would have to invest that somehow. When people sell something, they may be very pleased that they took all of that money out. However, if it hadn’t occurred to them up to that point, they have to begin to worry about reinvesting issues. This approach gives this owner a chance to reinvest the money in his own property, one that he knows quite well.
The new deal has the Him and Me LLC paying $6 million for the property. You must give him $1,700,000 and pay off the $2.5 million mortgage, so you need $4.2 million to complete the transaction.
The $4.2 million you need to borrow is 70% of the total property value. With this figure in mind and your contract in your hand, you and the owner go to the bank together. Hand them your contract showing that the Him and Me Corporation just bought this building for $6 million. You have $1 .7 million for the down payment. Therefore, all you need is a 70% loan to value, since the building carries itself.

Closing a Large Office Complex Deal
Finally, you can add stability to the deal for the purpose of borrowing. For example, let’s say you are considering buying a large complex with four different buildings, all ground floor level.
Six units are in each office building, so that’s a total of 24 units. The person who is selling has had the property for 15 years.
Since he has owned it for this length of time, there’s probably plenty of equity in the property. Fifteen years ago in Fresno, California, he may have built a complex like that for $80 to $90 a square foot, including the land. Today it would take $200 to $300 per square foot range to construct the same building.
So, the passage of time has created a lot of “monopoly money” in this deal. These are condo-ized units of 1,500 feet each that usually rent for $2,500 a month.
To calculate the PRI, take 24 x $2,500 a month or $60,000 a month, which totals $720,000 a year. So, we will assume that after subtracting expenses, the NOI would be about $500,000.
Now, in Fresno most people are obtaining an 8% “Cap Rate” for a deal like this, so you can be sure that it’s priced at approximately $6 million. If he started out financing 100% of the deal 15 years ago and paid $90 for the land and buildings, he paid $3,240,000 for the property.
He probably financed it for between 7 and 8%. If he borrowed 100% of the costs and then refinanced it immediately thereafter, he would still be about $2,500,000 in debt.
If he is an older person, he probably is seriously motivated to execute this deal—that’s why it’s for sale. However, it’s not an ideal situation for you to be approaching him about it. People who don’t have their property for sale, normally haven’t put a price tag on it, so it could be out of your reach.
To start the deal negotiations, you offer to pay $6 million with an additional motivator—if the property appraises for $7 million, you’ll give him $7 million.
You want to make as many assurances as necessary to make him comfortable with this deal, but you’ll need help to do this properly. That help is going to solve a few extensive problems that he might have when officially listing the property for sale.
What you’ll eventually want him to do is partner with you. However, do not offer that condition until you have a signed contract. Then, later that day or the next, arrange to meet with him again and mention that you thought you should have one more meeting with him before you start to raise funding.

You want to make sure that you have enough leverage and can use the bank’s money to make more money in this deal. Then propose the partner relationship to him. After all, he has to do something like reinvest this $3.5 million that he’s getting out of the deal.
Then you can suggest that he should leave approximately half his equity in this deal, about $1 .7 million, and you two can continue together as partners. You won’t need any other partners. You’ll take care of all the day-to-day activity and send a report to him in the mail every quarter, along with a good-sized dividend check.
Tip: Paying dividends quarterly is better, because it could be a fairly large amount of cash.

Financing Equity (Sellers as Partners)
The reason a seller will stay in your deal is because this is a deal that they already know and like—it’s a deal they already bought. They own it already; so they know it’s a good deal and you don’t have to convince them of that. Treating Capital Gain If a seller who currently owns the property has to be convinced that this is a good deal, then you missed something.
It helps to reduce or even eliminate capital gain when the seller stays in the deal because when you contribute equity to a partnership, that entity will own a piece of real estate.
That’s a nontaxable event—not a swap or a 1031. It’s allowed by a Section 541, IRS code, and it says, “When you make a contribution of a property to a partnership in return for an interest in that partnership, that is a non taxable event.”
You literally pay no tax on the money in the deal. If you take cash out of the equity contribution, that cash is taxable. For instance, if the ‘Me and You’ LLC is going to own some property together, so you contribute half your equity to the partnership. The other half you are receiving in cash is considered by the IRS as taxable capital gains.
Even though this is not an installment sale, the tax is figured on your half exactly the same way as it’s figured on an installment. The first payment you receive from an installment sale is taxable, but the dividends you receive from that point on are not. They are ordinary income or dividend income. Then sometime later, when you sell this property again, you will accrue another capital gain for that half of the deal.
So, you’ll receive a large portion now and more income over the years, while acquiring the remainder later. However, when you initially contribute your equity to that partnership, it’s not as if you sold the deal and paid half of it back. The half you are leaving in the deal is not taxable.

Equity vs. Debt
Financing commercial deals, as with financing any other kind of deal, is always a combination of equity and debt, with equity being the primary ingredient.  It may be not be necessary to have a loan, if you and your partners can handle the whole deal with cash, however most of the time; you’re going have a combination of debt and equity.
The cash flow isn’t better just because you don’t have debt in the deal. It’s just that more of the cash flow goes to service debt if you’re more highly levered.
Equity vs. Debt Ratio
So, if you’re sponsoring a deal, it would be smart for you to recruit as much equity as possible and have no or very little debt in the deal. However, even if you have about 50-50 debt vs. equity it will usually be a very workable deal. This presumes that you are borrowing money at a rate less than the overall rate on the property, so you have positive leverage.
If you borrow money at 6% on a property that’s throwing off income at 10%, you have 4% left over. That money goes to your partners. The concept is to use other people’s money (OPM), which gives you leverage on your money.
Remember there is an extra benefit from the fact that you’re borrowing some of the money at a rate lower than the overall rate in the deal.
Tip: After awhile in this business, if you sign on a lot of debt, you are much more powerful than the bank.
So, with equity or debt, you should always be raising money from other people. You’ll even get repeat customers—people who have participated in your deals and want to deal with you again.
Raising Equity
You raise equity from the following groups in this order:
1. Sellers
2. Tenants
3. Other people (partners)
Raising Debt
You raise debt from the following groups in this order:
1. Sellers
2. Banks
3. Finance Companies
4. Individuals
Tip: You don’t really raise debt from mortgage brokers, but they can steer you to individuals with equity money.

Financing Commercial Property
Introduction
Usually, when you are financing a residential property, the banker wants to know your personal three C’s:
• Cash flow
• Credit
• Collateral
Cash Flow
What a banker wants to know about your deal are these three Cs. The questions that need to be answered are:
• Where is the cash coming from for the payments?
• What is the measure of that income (income to loan ratio)?
• If you’re buying a house, what is the fair market value?
Sometimes the economy will determine if the loan is made. For instance, it could indicate that 30% of one’s income ought to be enough to make the payment on this house. If it weren’t enough, they would not make the loan. A benchmark of 30 to 35% income-to-loan ratio is customary in the residential market.
Credit
If your credit measures up to the criteria for a specific bank or financial institution, then you pass. For example, they might require a particular FICO or Beacon score.
Collateral
If you’re buying a house, your collateral is the house. If that house isn’t valued at a certain amount, you can’t get a loan. This is the reason that all homes are appraised as standard procedure for obtaining a loan.
Three C’s of Financing Commercial Deals
Financing commercial deals is much easier than financing residential deals. Again, the banker wants to know your three C’s, but these are ones related to your business:
• Cash flow
• Collateral
• Credit
Cash flow is still there, of course, but now it’s not how much income you have, but how much income the deal has. Banks look at the cash flow of each deal—not the individual who owns it. A residential property usually involves one or two individuals, unlike most business deals, which can have many owners.
The second C is collateral, which is more important than the credit of the borrowers in a commercial deal. The bank is interested in the income from an income-producing property because they know that is what will support the loan, not your personal income.
The third C is the real credit of the borrowers. That’s one of the reasons that you can more easily finance a commercial deal, as it does not depend nearly as heavily on your personal credit.
Tip: Your three C’s may change if you have a very inexpensive deal. For example, if you’re the only borrower for a small duplex and the cash flow is somewhat uncertain, you may find yourself borrowing from consumer lenders. In that case, your three C’s will be in the previous order and treated as if it were a loan for a residential property.

Selecting a Discount Rate
Several factors can influence your choice of a discount rate:
• Inflation expected in the future
• Risk perceived in the investment
• Other opportunities available in the marketplace
Inflation
The effects of future inflation are a significant factor in your selection of a discount rate. As a general rule of thumb, you always want to have your “Cap Rate” higher than your borrowing rate. Otherwise, negative leverage may occur.
If you buy something that produces 10% and you have to pay 12% to acquire it, the more you borrow, the less money you’re going to have, resulting in negative or reverse leverage. If you borrow too much, you can actually use up all the income and have to support the property, instead of the property supporting you.
Risk
Risk is evident in determining what class of building you will consider for your investing portfolio. For example, your “Cap Rate” will be higher on a Class C office building than a Class B building, and Class A buildings sell for much lower “Cap Rate”s even still.
As you can see, there is a higher risk in an older building with greater functional obsolescence. It could be in the wrong part of town or in an area where vandalism is a problem.

Direct Capitalization Formula
Perhaps half of all investors use this next rule of thumb to rule out properties that won’t work for them. It’s commonly called Direct Capitalization or the “Cap Rate” approach. Some investors know this Capitalization Rate (“Cap Rate”) or Discount Rate by other names, such as the Hurdle Rate or the Opportunity Rate.
IRV Rule of Thumb
The “Cap Rate” is typically talked about among realtors as the IRV rule of thumb: Income divided by Rate equals Value. The lower the discount rate, the higher the value and, inversely, the higher the discount rate, the lower the value.
It’s slightly confusing even in the real estate industry, because when appraisers talk about Capitalization Rate, they mean something entirely different than when investors use the term.
An appraiser’s capitalization rate is a thing of beauty. They use a Discount Rate that’s part of their Capitalization Rate. They compute that discount rate very carefully from historic sales, which means that they’re always behind the times—by months or even years.
Much of the total “Cap Rate” that they use is what investors think of as the actual “Cap Rate”. However, they call it the Discount Rate.
The Discount Rate is a large part of what investors count as the “Cap Rate”, with a small piece included termed the Capital Return Rate. This element is used to differentiate between two buildings of different ages.
For example, when comparing two 40,000 square foot buildings that each has 10 tenants, gross income of $100,000, and a 7% vacancy rate, you might think that they are very comparable properties. However, once you find out that the first building is 100 years old, while the second one is only 15 years old, it becomes a different situation.
You might agree with the appraiser that the 100-year-old building is worth less than the building that’s only 15 years old. Logically, the older building will fall down before the newer one, so that small component of the appraiser’s Capitalization Rate, the Capital Return Rate, factors into this element.
Some of the “Cap Rate” is return on investment, so appraisers also take that into account when appraising your property. They use a Capitalization Rate that’s composed of two elements:
• Discount
• Capital Return
Real estate investors only use the Discount Rate, which is the raw return for the first year that they’d like to get on their investment. Some investors think of it as the rate of return they’re getting on that investment.
So if you want 10% on your investment and the property is producing $100,000 of NOl, you can afford to pay $1,000,000 ($100,000 divided by .10). If you needed 12%, you would only pay $800,000 ($100,000 divided by .12).
Key Point
The higher the Cap or Discount Rate, the lower the value of that property. To earn 15% on your money, you should be willing to pay less than if you want only 10%.

Calculating Cash-on-Cash
Example
Cash-on-cash is another seemingly more logical progression. Many real estate investors only want to hear about the cash that you make on the cash that you invest. They want to know what the relationship is between how much you had to put down on the property on and the return that cash produces.
For example, if you went to the closing table, put $70,000 down, and had about $15,000 worth of expenses, your initial investment was $85,000. At the end of the year, you have $10,000 in your hand from the operation of the building for that year. That’s what’s leftover after you paid the mortgage and all associated expenses, but before you pay your income tax, (although some people calculate cash-on-cash after taxes).
To see how that compares with what you invested in the cash-on-cash equation, take the $10,000 left over at the end of the first year’s operation (that year’s NOl) and divide it by your initial investment of $85,000. That equals a cash-on- cash return for that first year of 11.76% or almost 12%.
Even after you complete this cash-on-cash equation, you’re not finished. You must still subtract any existing debt service from this NOl before you finally have a number that represents your approximate cash flow before taxes.
For perhaps one-third of all real estate investors, cash-on- cash is a more meaningful number, but it certainly is more complicated to compute. Almost all the numbers in the calculation are estimates, whereas the only number you need in the other formula is your GRM, which is based on your research in the market.
You can usually just look at a flyer for the property to determine the GRM. It tells you rent values and the property price, so you’ve just been handed your GRM—divide the price by the gross income. You might even find a flyer on the Internet or a broker with properties listed might mail it to you.
It’s not so easy to use the cash-on-cash calculation since you must have much more data. Most of the information will not be in a flyer, because the estimations aren’t made yet. You would have to obtain a full property package to even come close to guessing some of those numbers.