Traditionally, banks have lent up to 80% of the value on commercial real estate, especially where the historical cash flow from the property was sufficient to cover debt service and operating expenses. Of course, the borrower’s credit score always impacted this decision, and typically a score above 650 was required. Today, it is a very different world. Even if a borrower has a credit score above 720, (considered excellent), many are finding it very difficult to obtain conventional financing (if not impossible). Banks are requiring much more in terms of down payments, much higher credit scores, personal long term relationship with the borrower, historical data as it relates to rent rolls on commercial property, heavy documentation for proving income and net worth, multiple appraisals (lenders cannot even communicate directly with the appraiser anymore), yearly updated performance information to make sure the property is continuing to perform strong, and it is critically important for a project to have a competitive edge and stand out among the mass quantity of real estate available.. This is the new norm when it comes to obtaining financing for commercial real estate.

Therefore, it is important to explore alternatives. Alternative financing typically comes from:

(1) Owner financing;
(2) private hard money lenders;
(3) private equity investors and/or
(4) SBA loan programs offered through The American Recovery and Reinvestment Act of 2009 (signed into law by President Obama on February 17, 2009.)

We will examine the pros, cons and pitfalls of each of these strategies. However, since taxes, real estate and financing go hand in hand, a brief discussion of tax based incentives is necessary because the new norm is that the tax benefits may be the edge needed for a real estate project to attract investors.

TAX BASED INCENTIVES:

Low-Income Housing Tax Credit

For developers of multi family low income housing, the low income housing tax credit has been of great assistance. However, since the introduction of the passive loss rules from Tax reform Act of 1986, these credits are typically used by corporations to offset the entity’s taxes dollar for dollar. These state awarded credits can be of great assistance for a developer to attract private equity investors to fund their projects. Typically, the private equity investors are given these credits as an additional incentive to invest in a particular project. The highlights of how this credit works are below:
1. This federal tax credit, in general equal, is equal to about 9% of the qualified cost and improvements of the property per year for 10 years;
2. Development capital is raised by “syndicating” the credit to an investor or group of investors;
3. A developer will typically propose a project to a state agency, seek and win a competitive allocation of tax credits, certify the project cost, and rent-up the project to low income tenants;
4. The credit will be based on (i) the amount of credits awarded to the project in the competition, (ii) the actual cost of the project, (iii) the tax credit rate announced by the IRS and (iv) the percentage of the project’s units that are rented to low income tenants;
5. Simultaneously, an investor will be found that will make a capital contribution to the partnership in exchange for a percentage ownership in the project and an agreed upon allocation of the credits over a 10 year period. The investor will either fund a portion or all of the financing needed. If it’s a portion, the investor’s contribution of equity and borrowing strength can greatly enhance the chances of a particular project obtaining conventional financing.

There are additional detailed rules that describe the lengthy application process, program administration, terms & conditions, eligible basis, credit limitations, compliance, and what qualifies as low income housing. This goes beyond the scope of this discussion.

Empowerment Zone & Renewal Community Employment

Wages paid to employees working in selected geographic areas qualify for this credit. The IRS lists each year in their Form 8844 which areas are Empowerment Zones and which areas are renewal Communities. The Empowerment Zone credit is 20% of wages up to $15,000 and the Renewal Community credit is 15% of wages up to $10,000. If real estate is developed in any of these areas, you can use these credits to enhance your return by lowering dollar for dollar your Federal taxes accordingly. You can find out if your specific location is within one of these zones by calling 1-800-998-9999 or using the address locator at http://www.hud.gov/cr/locator.

Commercial Revitalization Deductions for Investors, Developers and Business Owners

As an investor, developer or business owner specializing in redeveloping in abandoned and underutilized buildings or new construction in Renewal Communities (which you can check with your local county to determine where the Renewal Communities are located), you are eligible for special federal tax deductions called Commercial Revitalization Deductions (CRD).

The CRD is a federal tax incentive that is deducted from a business’ income before calculating federal income tax liability. With a CRD, you can deduct a portion of the costs of acquisition and substantial rehabilitation over a shorter period than permitted under standard depreciation rules. Specifically, this competitive tax deduction allows you to EITHER deduct half of your eligible building expenses during the year that the building is placed in service or prorate the same expenses over a ten-year period.

Additionally, if a business holds a Renewal Community Business asset acquired after December 31, 2001 and before January 1, 2010 for a minimum of 5 years, the business does not have to include any “qualified capital gain” from the asset’s sale or exchange in its gross income. This exclusion applies only to an interest in, or property of, certain businesses operating in a Renewal Community (RC). The following qualify as RC assets: RC business stock, RC partnership interests, RC business properties. Only gain attributable to the period from January 1, 2002 through December 31, 2014 may be excluded for RCs.
There is a lengthy application to qualify and each application is scored based on various criteria beyond the scope of this discussion. For more information, go to http://www.cdconline.org/rccommercialdeduct.htm. Again, these tax incentives are very effective for raising capital from private equity investors.

Cost Segregation Study

If you have built or renovated a building in the past 10 years, cost segregation is a tax savings strategy that can improve the economic health of your bottom line by accelerating the manner in which you recover the investments in your building. Property they may be classified as 27.5 year or 39 year property (meaning it has to be depreciated over this long useful life) could be reclassified to 5, 7 or 15 year property through these studies. These studies need to be performed by qualified CPAs and engineers to meet stringent IRS guidelines, but can be well worth the money. This enhanced depreciation deduction can be very attractive to investors to help fund your project.

Energy Efficient Commercial “Green” Tax Deduction

Have you built an energy efficient-building or upgraded your HVAC or lighting system to reduce energy consumption? If so, you may qualify for a tax deduction of $.60 to $1.80 per square foot off the cost. Again, this study should be performed by a qualified CPA firm that specializes in this area and typically is done simultaneously with a Cost Segregation Study. The property must be certified by an unrelated qualified and licensed engineer or contractor which the CPA firm can coordinate. Taxpayers must retain these certifications in their tax records.

Energy-Efficient Home Builders Credit

Contractors that build new energy-efficient homes in the U.S. may claim a tax credit of $2,000 per dwelling unit for homes sold after 2005 and before 2010. The IRS has issued guidance on the certification process tat builders must complete to qualify for the credit.

ALTERNATIVE FINANCING:

SBA Loan Programs offered through The American Recovery and Reinvestment Act of 209 (signed into law by President Obama on February 17, 2009).

There are two new key provisions in the Act that are geared towards helping small business owners: (1) Temporarily raising guarantees up to 90 percent through calendar year 2009 or until the funds are exhausted and (2) temporarily eliminating fees for both borrowers and lenders through 2009 or until the funds are exhausted. However, what isn’t always discussed is that these loans are still very difficult to get. One must typically go through their bank, or credit union to apply for these loans and according to the SBA, these loans is meant to assist borrowers who are unable to obtain financing on the same terms through normal lending channels. Therefore, the borrower must first apply for a loan and go through a normal underwriting process. Once declined, the lender will then explore the SBA loan. If the SBA makes the loan, they are in essence guaranteeing the bank on the loan if you default. Therefore, you need to be very prepared to go through a rigorous loan application process that in many cases is tougher with the SBA then a conventional bank loan. It is true the SBA will approve folks with a lower credit score then a conventional bank loan, but none of the other underwriting standards are relaxed. Your tax returns, books and records, detailed financial and verbal description of your project, detailed architect drawings, and an incredibly strong property will be required to get the SBA to approve your loan. Perhaps the most surprising part of applying for an SBA loan is when you here that you’re not strong enough to qualify for their unsecured loan guarantee and that you need real estate to obtain the loan. In other words, my experience with the SBA loan programs is that unless you have strong real estate to secure the SBA loan, your chances of obtaining the loan drop considerably.

Owner Financing

Sellers are realizing more and more that they can’t sell their properties because banks aren’t lending to buyers. Therefore, for buyers, this is an advantage. Don’t be afraid to ask a seller for owner financing. Make them an offer, in writing and request owner financing with rate and terms similar to conventional banks. A savvy seller will certainly want a significant down payment (at least 20%) and likely still request to pull your credit. However, many of the other normal underwriting processes you will have to go through for a normal bank loan may not be required. Also, don’t be afraid to explain to the seller the advantages they have by making you a loan. For example, the seller will not have to recognize all the gain on the sale of their property in one year. Under the installment sale rules, when a seller provides owner financing, they defer the gain for tax purposes and recognize only a portion each year in relation to the payments they receive from you. Additionally, this creates a nice income stream for the seller and in the event of a default; they keep your down payment and can resell their property after a successful foreclosure. Remember, banks made a fortune for many years by providing loans and a seller knows their loan is very secure because after all it’s their property that is securing the loan. Owner financing is and will for the foreseeable future be the norm for financial commercial real estate deals.

Private Equity Investors

Over the past few years, private investors have been spooked. They have been scammed by fraudulent appraisers, by over valued properties, and by the general down turn in the economy. This recession didn’t spare any investment category. Real estate, stocks, bonds and commodities all took a major hit. Therefore, it is very difficult to find private investors with an appetite for real estate unless they are getting an absolute amazing deal. This means they must be convinced that they are buying a property for pennies on the dollar, and that the yearly cash flow is tremendous. Also, they will want to know that your deal stands way above the rest. The tax incentives mentioned above may be the edge you need to get private investors to fund your deal. Be prepared to be underwritten by private investors every bit as hard as banks. Also, be prepared to give up legal control of your deal. Today, the norm has become that the money partner wants to know they control the shots. The days of trusting the developer partner to do all they promised and the equity partner puts all the skin in the game for only a small fraction of the deal are gone. Also, they will want to see you put skin in the game meaning you will have to come up with part of the cash. It’s not good enough anymore to only contribute your sweat equity. Those days are gone. Investors know that cash is king and without them, deals won’t get done. So explore this option very cautiously as your equity partner will likely be controlling your deal.

Private Hard Money Lenders

Hard money lending typically is thought to be a means of last resort. Interest rates will usually be 3% to 5% higher then conventional mortgages, and closing points will be 5% to 10%. These types of lenders are still lending but they are heavily scrutinizing the loan to values. They focus less on the financial strength of the borrower and more on the strength of the property. It used to be that hard money lenders would lend 70% or less of the value of the property. That is no longer the norm. The new norm is 60% or less of the value of the property, and they will not solely rely on an appraiser’s determination of value. Rest assured that if the purchase price of the property is less then the appraised value, the appraised value will be ignored. Also, they will no longer attribute value for a planned re-zoning. If you’re zoning and permits are not already in place, the property will be valued for its current zoning and use. Potential uses are a thing of the past. Although this alternative may seem inferior to using private equity investors, this is not necessarily true. One must evaluate the price of each because these days, the norm for private equity investors is to take a large chunk of the equity in you project (usually the investor will not want control, which means owing 51% or more of your project). Alternatively, a hard money lender will charge high interest rates and closing costs, but this is usually far less then 51% of the equity in your project. Typically, you will be giving up 10% to 15% of your project by using a hard money lender. If you believe your property will be strong and performing well in a relative short period of time (1 to 3 years), this could allow you to obtain conventional financing and payoff the expensive hard money loan. Therefore, this alternative may be far less expensive then using private equity investors.

Good Books & Records is Key (QuickBooks)

You must have absolute perfect books, records and documentation. All tax reruns must be filed accurately and will need to demonstrate that you and your property have the ability to cover the debt, taxes, insurance and operating expenses of a property. Also, this will make your life much easier come tax time. QuickBooks is an easy and cost effective solution to maintaining accurate books and records for your project. Consider engaging a CPA to help you properly set up your books and records, particularly as it relates to segregating the cost and improvements of your project between the various classes of property the IRS has identified. Furniture, fixtures and equipment for example can be depreciated over a 5 or 7 year period, while building costs or improvements have a much longer useful life of 15, 27.5 or 39 years. Also when you sell, abandoned or retire assets from your project, you want to be able to easily identify which assets to write off. The days of no documentation loans from banks, private investors and even hard money lenders are long gone. The new norm is to have crystal clean, detailed and accurate books and records both for the purpose of obtaining a loan and maintaining a loan. You will be asked for yearly (at a minimum) detailed accounting records on your project.

Entity Types

It is important to set up the right type of entity for owning your property. There are many legal forms in which a property can be owned. You can own it in your name directly (not recommended especially for liability purposes), own in an LLC, and S-Corporation, a regular corporation, a partnership, or as tenants in common. Each has very different tax consequences associated with the form of ownership. Consultation with an attorney and an accountant for further advice is highly recommended. But the new norm is that your form of ownership must maintain its own books and records and co-mingling of funds between the entity owning the real estate and your personal funds can have detrimental legal and tax ramifications.

Passive Loss Rule Considerations (Real Estate Professionals versus Non-Real Estate Professionals)

There are a complex set of rules that were introduced with The Tax reform Act of 1986 which in essence limits the amount of yearly loss a non-real estate professional can use. Real estate professionals, however, can utilize all of losses generated from a property for tax purposes. The rules and IRS scrutiny on who qualifies as a real estate professional are complex. Again, essential you consult with an attorney or CPA to assure you’re classifying yourself correctly and otherwise complying with the passive activity loss rules. The IRS is scrutinizing real estate losses very carefully these days due to the downturn. The new norm is expect to be audited and therefore maintain your books, records, and take tax positions in a manner that you can fully support to an IRS agent. Believe me, they won’t just take your word for a deduction or position you may have taken on your return. Proof of everything is the new norm.

The new norm has made thinking out of the box critically important. The days of stated income, no doc loans are long gone and may never return. Be prepared to have accurate detailed records for everything. Be prepared to go through very long underwriting processes. Be prepared to be rejected. However, the right projects with the right competitive edge can still find financing alternatives as described above. The new norm is that your monthly rent should be at least equal to 1.5% of the total cost of your project, including acquisition costs and all improvements.