Brian Kimmel, Assistant VP of Commercial financing, sees it all the time. A prospective client will approach him looking for financing on what the client thinks is a valuable property. Kimmel does a cash flow analysis and delivers news that’s often shocking. From a cash flow perspective, the building isn’t worth what the borrower thinks.
In Kimmel’s view, cash flow is a fairly misunderstood concept, especially among novice or unsophisticated investors.
“First National is a cash flow lender,” says Kimmel. “For a cash flow lender, the revenue a property is able to generate always outweighs the asset value. Our main concern is mortgage serviceability.”
The cash flow conundrum
Kimmel often uses an illustration to help prospective clients understand the cash flow conundrum.
A client is buying an office building for $10 million. The building has some vacancy and several other pressing issues. The client is looking to secure $7.5 million in financing (75 per cent loan to value) and is investing an additional $2.5 million of his own money.
To the borrower, it’s pretty cut and dry. The building is worth $10 million. Asset value is high, so financing should be a breeze.
It’s here that Kimmel usually interjects and sets the client straight. The building may be worth $10 million, but does it have enough cash flow to service the $7.5 million loan?
“I find that some borrowers are unfamiliar with the factors contributing to cash flow issues,” says Kimmel. “It can be any number of things from vacancy and abnormally high expenses to inflated purchase cost and building mismanagement.”
Cash flow is Kimmel’s biggest concern. If the building can’t service the mortgage in question, its market worth is inconsequential from a financing perspective.
For Kimmel, a key part of his role as trusted advisor is to help clients manage challenges such as cash flow shortfalls. He recommends three ways that borrowers can bridge the cash flow shortfall including:
- Investing additional equity until the cash flow situation improves
- Providing collateral security on other properties
- Securing secondary debt that may be higher in price but requires less cash flow coverage
A surprising answer for one borrower
A novice investor was looking to purchase a six-plex in a highly desirable neighbourhood in Toronto. Based on the value of the area, buildings are pricey, sometimes going for close to $500,000 per unit.
However, rents can only go as high as the market will bear. For this specific area, one-bedroom units were only fetching $1500 per month. Based on a cash flow analysis, unit worth was closer to $200,000, rather than the asset value projection of $500,000.
As a result, Kimmel was only able to offer a 30 per cent loan to value on a traditional financing basis. The building’s cash flow could only service a mortgage of $150,000 per unit. While the asset value of the property was high, the cash flow was insufficient to support the type of financing that the borrower was seeking.
“Newer real estate investors need to crunch the numbers realistically and understand how important cash flow is to a lender like First National. It can be the best building in the world, but if there isn’t positive cash flow, it may not be a fit with our mandate. If the borrower is open to being inventive, we can work together to get the deal done,” says Kimmel.
First National Financial LP (Ontario Mortgage Brokerage License No. 10514)