The ins and outs of owner-occupied refinancing

Q. I own a building that is fully occupied by my business, with a small SBA 504 loan balance. I want to refinance the building and take out some of my equity, what is my best approach to a lender?

A. You are seeking what the mortgage banking industry commonly calls owner-occupied refinancing — a specialty product that is not offered by all lenders. Many lenders that do provide owner-occupied financing will want to encumber both the assets of the business and the building. To maintain flexibility for your business and not have to encumber it with the building loan, a separation of the two must be created, i.e., the business effectively becomes a tenant in the building, paying arm’s-length rent.

The primary step is to have two separate ownership structures. Ideally, both will be separate legal entities (limited liability companies or corporations, for example), but one of the two can be owned individually. If new legal entities are to be formed, there may be tax implications that should be reviewed with legal and financial advisers.

The concept is to create an income-producing building in which the business (operating company) is a tenant paying rent to the real estate ownership or landlord. In so doing, the loan amount is underwritten predicated on the rent payment. A lease will have to be drafted between the ownership structures and the term of that lease will likely have an impact upon the financing alternatives available to you.

Lenders like longer-term leases obligating the tenant to pay rent and therefore minimizing the risk of a building vacancy, but tenants prefer shorter-term leases maintaining their flexibility. Typically a seven- to 10-year lease will be acceptable to both interests.

Establishing the rent to be paid under the lease is very important, as the rent cannot exceed market rates, must be sufficient in order to support the loan amount being requested, but must also be affordable for the operating company.

To identify a starting point, you might seek counsel from a commercial real estate appraiser or counselor who can advise you of the comparable market rental rates for similar properties in your market. It would be usual for an owner-occupied structure that the rent be completely “net,” meaning that the operating company pays all of the building operating expenses. Structural components such as roof, walls and infrastructure are typically real estate ownership responsibilities.

Once the rental rate is established, the rental income will be underwritten in order to identify the loan amount.

Underwriting criteria can vary depending on the type of lender, but typically there will be deductions from the rental income for a credit loss factor, minor professional fees and some sort of building structural and replacement reserve. The remaining income commonly called “net income” is then further underwritten with a debt service coverage ratio (dscr) to arrive at the income available to support the debt service.

The accompanying chart illustrates an example of $126,500 in rent being necessary to support the annual debt service of $89,500 for a $1 million loan with a 1.3 dscr at a 6.5 percent interest rate with a 20-year amortization.

The final step is to illustrate that the operating company can afford to pay the $126,500 rent required under the new lease and still remain profitable. That illustration should be presented on both a historical basis and with future projections. Most lenders will want to analyze a historic three years substituting the $126,500 proposed rent for the actual rent or debt service paid during that period.

A pro forma for the upcoming year or sometimes several years also will be necessary, illustrating the effect of the proposed rent.

If the operating company can still maintain reasonable profitability with the proposed rent, then the requested loan amount should be achievable. If not, the loan amount will likely have to be adjusted.

David B. Eaton, president of Eaton Partners, Manchester, manages the firm’s commercial mortgage group. Questions can be submitted to him at

How refinancing pays

refinancing pays
Rent $126,500  
Loss, Professional Fees & Structural Deduction
Service Coverage
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