5 minutes
“Never loan money to any business when you don’t understand the nature of the business,” said Jim Devine, founder, chairman and CEO of Hipereon, Inc. Devine was lead faculty at the CUES Advanced School of Business Lending: Commercial Real Estate Lending , held September in San Antonio, where he walked students through different kinds of commercial real estate properties.
Credit unions considering these types of loans need to understand the soundness of the various types of properties as a business entity and, potentially, as the collateral for a commercial real estate loan.
Commercial Office Properties
Advantages: Commercial office buildings typically have a diverse makeup to their income streams. They tend to have several different tenants, each with a unique leasing arrangement with the property owner.
Plus, the property owner can generate revenue from other sources like parking.
The majority of office tenants do not require significant leasehold improvements in the space they occupy. Office spaces tend to be fairly similar from one type of business to another. Another advantage: Office buildings tend to physically hold up longer. They are typically better maintained and don’t tend to get abused as much as housing or hotels.
In many cases, office tenants pay a maintenance fee each month to cover property security, utilities, property taxes and maintenance.
Disadvantages: The property owner needs to provide adequate parking and ease of access from both public and private transportation options.
The building’s operating systems (utilities, access, security systems, elevators, escalators, heating and cooling systems, etc.) must be in good functioning condition at all times.
As a lender, you need to consider:
Physical location and the amount of available office space in the same relative market location. Is there a large supply? Not enough? Is there a building boom? What are the existing and projected vacancy rates and market absorption rates for the area?
Condition of the property: Is it a functionally sound building with all related operating systems and property access options in good working order and physical repair?
Current mix of tenants: Who are they? What are their individual lease terms? How successful is each tenant’s business? As the lender, you need to determine the continuity of the property and the predictability of the property income levels and cash flow.
“As a general rule of thumb, we like office properties,” said Devine.
Industrial Properties
“In contrast to office space, industrial space is pretty problematic,” said Devine.
Advantages: Industrial properties can cover a wide range of property types, ranging from manufacturing to warehouse-type facilities.
Manufacturing facilities tend to be owner-occupied or have a single tenant.
Warehouse facilities are functionally more generic than manufacturing ones and therefore can be easily updated for new tenants without a lot of physical changes to the building.
Disadvantages: It can be challenging to find a new tenant for a special use manufacturing facility.
Selling or leasing the space may require major changes or improvements to the building to make it work for a new purpose.
Warehouse space is easier than if it’s a special purpose manufacturing facility that was designed for whatever was being built there, Devine said. He used the example of a former truck manufacturing facility that the owner is trying to release. “It’s a gigantic, 100-million-square-foot space to build trucks. It has lots of special purpose design stuff for making trucks, like venting.”
If you, as the lender, ever had to repossess the property, consider: How much do you have to change the building for another manufacture to come in?
The demand for warehouse space is very cyclical, said Devine. If the market is saturated with warehouses, your borrower’s property could sit unoccupied for a long time.
But the biggest concerns for lenders, according to Devine, are environmental ones.
“Environmental issues jump way up on the radar screen here,” he said. “Always check with industrial properties: What exactly they are doing and the processes they are using. If you ever took it back as collateral, you inherit cleanup responsibilities.”
Retail Properties
Advantages: There’s a wide range of facility types, from strip malls to stand-alone shops to large shopping centers.
For the most part, each property has multiple tenants, resulting in a diverse income stream for the property. Also in many cases, property owners can tie rent levels to the retail sales volume produced by the tenant. Plus leases tend to be for at least five years or more.
Tenants pay for leasehold improvements they require for their individual use. Common area maintenance is paid for by tenants based on the percentage of the overall retail space they occupy.
Disadvantages: Location is extremely important. Retail properties should be in high traffic areas and have at least one of the following: convenient parking, public transportation and pedestrian access.
In addition, if the property has a large, anchor tenant, it can be very challenging to replace that tenant.
“You need to pick and choose retail. Be careful about retail,” Devine said. “A lot of small business sell nice-to-have items vs. need-to-have. In a shaky economy, those tenants will roll over quick. You need to be selective about retail because it is so cyclical.”
When considering funding a retail space, lenders need to think about:
- the demographic makeup of the market and the buying habits and purchasing power of the local consumer market; and
- whether the property owner (and the lender) possess a clear understanding of current and projected lease/rental rates and vacancy level rates for similar properties.
Multi-Family/Apartment/Condo Properties
Advantages: Lots of tenants equals a diverse income stream. On the other hand the more tenants, the greater the potential for rollover.
Disadvantages: Living space tends to have a lot of wear and tear. Property owners will frequently need to repaint and replace appliances and carpet.
They really require intense property management. “[Property owners] need to be on top of the tenant base,” said Devine. In addition, there could be special facilities, such as laundry areas and pools to maintain.
“I would be very selective about multi family,” he said.
Lenders need to consider:
- occupancy rates for the property and comparable properties;
- the physical condition of the property;
- whether the property’s core operating systems are in good working order.
Devine advised school attendees to think strategically about the types of commercial real estate loans they want to make. “Think about risk from a portfolio perspective,” he said.
“You will want to have a mix in your commercial real estate strategies. Consider: What kind of properties in our market do we want to finance?”
Theresa Witham is a CUES senior editor.
