Published August 1, 1998

Owner Occupied Financing: What are Owner Occupied Loans?

The Lenders Are Back

"To be or not to be" was the philosophical question facing Hamlet in Shakespeare's famous play. To lend or not to lend was the real question for bankers during the early 1990's when the real estate market collapsed. With few exceptions, banks are now cautiously making real estate loans again. Why? The reasons are many - higher loan demand, tighter underwriting guidelines for real estate loans, and relaxation of some of the federal regulatory rules and lowering the transaction costs.

For purposes of this article, Owner Occupied loans is defined as a borrower purchased building or "space," supported from borrower resources, arranged "take-back financing" with the seller and/or bank financing. An Owner Occupied loan is secured by a first deed of trust on the building, typically with the borrower renting and occupying the space. The lease payments directly support principal and interest payments on the loan. How much space in the building does the owner have to occupy to qualify? It depends on the lender - some banks require at least 50 percent of the building; some require 100 percent.

The popularity of owner occupied loans has surged in the Washington area, and the law of supply and demand has played a major role. During the early 1990's, business owners witnessed the Great Market Adjustment - a general collapse in commercial real estate values. Distress sales by cash-starved owners and foreclosure sales by lenders left the market saturated with office buildings, warehouses and retail outlets. Since business people were uncertain of the market and the economy, there was very little demand to keep pace with an overabundance of supply. The result - prices declined substantially. In late 1993, prices finally stabilized and in 1994 the economy showed apparent signs of a recovery, boosting business confidence.

Generally, Owner Occupied loans are priced at a long-term, fixed interest rate, which until recently were relatively low. All of the above made real estate purchases and financing attractive to business-owners. Currently, real estate values have improved from the dark days in 1991. However, despite higher prices and higher interest rates, bankers are still seeing a fair amount of loan demand. Apparently, some reasonably priced real estate remains on the market, and brokers claim that there are still bargain deals available. If they are correct, we will continue to see higher-than-average loan demand.

Another reason for the increase in Owner Occupied loans is that banks believe it is safe to cautiously venture back 'into the water". Real estate values have recovered to a point where bankers are comfortable making loans and taking real estate as collateral.

It must be emphasized that this overview does not extend to "investment properties" - borrowed funds for real estate purchased as an investment and leasing the property to third-party tenants (income stream). Bankers would classify this as an "investment loan" which is underwritten differently from an Owner Occupied loan. Most bankers prefer Owner Occupied loans due to the risk considerations.

During the Great Market Adjustment, bankers watched in horror as investment loans on fully leased buildings went bad because tenants moved to other buildings offering lower rent and other concessions. Without rental income, the borrower is generally unable to make scheduled loan payments.

By contrast, in an Owner Occupied loan there is little risk of the borrower-tenant leaving the building for a better lease de Moreover, in the normal Owner Occupied loan situation, personal guarantees for the loan are present.

Aside from their renewed confidence in real estate collateral, bankers have revamped the underwriting criteria for Owner Occupied loans. For example, the Loan to Value Ratio (LTV Loan Amount/Collateral Value) and Debt Service Coverage Ratio (DSC = Net Cash Flow from Operating Income/Debt Service) are two critical ratios studied by lenders during the underwriting process.

Assume the owner-borrower has elected to purchase and occupy 100% of an office building for $400,000, consistent with a recent appraisal, and the company generates $40,000 annually in cash flow after expenses. Before the Great Market Adjustment, many bankers relied on an 80 percent or more LTV (even 100%). LTV ratios above 75 percent are normally considered dangerous since there is inadequate cushion between the amount of the loan and the value of the collateral Currently, bankers have returned to safer LTV standards with few bankers going above 80 percent of the purchase price on any deal.

This same kind of discipline has returned as well to DSC standards. Bankers use this ratio to gauge the ability of a business to generate the necessary amount of cash flow to repay the loan.

Assuming annual loan payments for this loan are $40,000, the DSC would then be 1:1, or Net Cash Flow of $40,000 divided by Debt Service of $40,000. Before the Great Market Adjustment, the minimum DSC ratio was typically 1.2:1, but many lenders relaxed this ratio to 1:1 if they were comfortable with the business and the collateral.

Bankers have learned the hard way that despite the importance of collateral, Debt Service Coverage determines the fate of the loan. A cushion is needed to protect against unforeseen expenses, loss of income or any other disruption in cash flow A firm with a DSC ratio of 1.2:1 or higher is more likely to withstand these disruptions and repay the loan on schedule, than a firm with a DSC of 1:1 or lower who will probably nee to reschedule the debt - a message no banker wants to hear.

The last reason for increased interest in Owner Occupied loan involves banking regulations and transaction costs. The Office of the Comptroller of the Currency (OCC and the Federal Deposit Insurance Corporation (FDIC) regulate how banks ma lend with respect to real estate transactions. For example, until recently, national and other banks subject to OCC and FDIC supervision were required to have a comprehensive appraisal for commercial real estate loans over $250,000. In those circumstances, the borrower would be required to incur appraisal costs ranging from $3,000 to $6,000. Earlier this year, banking regulators relaxed the rules for Owner Occupied loans under 1,000,000. Banks are no longer required to order a full appraisal. Transaction costs are consequently lower. In fact, one bank is making Owner Occupied loans and considering the collateral under the regulations as "an abundance of collateral," where no appraisal is required at all. Eliminating the appraisal requirement clearly allows a less expensive and faster loan settlement for the borrower.

Owner Occupied financing has returned and there still appears to be real estate opportunities in this area from the Great Market Adjustment. Although long-term interest rates have increased during 1994, many analysts are projecting even higher long-term rates in 1995.

For small and medium-sized businesses, the decision to seek Owner Occupied financing is a significant business decision. One should analyze the following: leasing, determine and evaluate future space needs, consider the tax consequences and, above all, establish realistic Projections that support adequate cushions to repay the loan. The economic consequences of default are both serious and often terminal. The owner should fully evaluate his options including the counsel of his attorney and accountant.

Banks have returned to the Owner occupied lending with qualified borrowers. if you have a solid purchase package, find the lending institution best suited for your specific needs and objectives. Borrowing from Hamlet, the question arises whether "tis nobler to" own, "or suffer the slings and arrows of outrageous" lease payments. For the qualified firms, Owner Occupied financing can increase financial leverage and result in a very beneficial step in the long term growth cycle.

Kevin P O'Brien, Senior Vice President, Riggs National Bank of Washington, DC; Adjunct Professor Real Estate Law, George Mason University School of Law (301-986-7610)