Real Estate advisor. Protecting your income with business interruption insurance. March April Ask the Advisor. A loan primer

Transcription

1 Real Estate advisor March April 2012 Protecting your income with business interruption insurance A loan primer It pays to know the rules SMLLCs: The good, the bad and the ugly Ask the Advisor How can I build a better loan request package? Mount Arlington Office Newton Office

2 Protecting your income with business interruption insurance The past decade or so has highlighted the need for commercial real estate owners to obtain and maintain appropriate insurance coverage. Events like the Sept. 11 terrorist attacks and Hurricanes Katrina, Rita and Irene left hundreds, if not thousands, of properties temporarily or permanently unusable and thus unable to generate their usual levels of income. Business interruption (BI) insurance can help you augment your income stream for the period that tenants can t fully use their space or that you re unable to fully conduct business. This type of coverage typically isn t sold as a standalone policy. Instead, it s added on to your property or comprehensive business insurance policy. Such coverage is especially important if you count on rental income to service your debts. How it works BI insurance compensates a company for income lost when it must suspend normal operations because of physical damage to its property or a civil order requiring the business to close. Property insurance covers only physical damage to your property. But BI insurance provides capital to pay salaries, benefits and extra expenses incurred (over and above those normally incurred) to mitigate its insured loss. Your policy should clearly define suspension of operations. Without a clear definition, the insurer might attempt to deny coverage if you don t suffer a complete shutdown. BI policies typically limit the period of recovery. This period of restoration generally runs from the date of suspension of operations to the date of completion of repairs or the date the property is returned to the same operating condition that existed before the disaster. Policy terms vary greatly. A policy may prescribe, for instance, a specific period of recovery, a maximum period of coverage or a maximum recovery per month. You also can obtain extended coverage for the period between the completion of repairs and your return to normal occupancy. Your policy should clearly define suspension of operations. Without a clear definition, the insurer might attempt to deny coverage if you don t suffer a complete shutdown. And the insurer will cover only losses directly attributable to the damage, as opposed to, for example, those partly due to a slow rental market. 2 How lost income is computed BI insurance aims to make commercial property owners whole after a disaster has caused a temporary shutdown. Policies compensate for lost income, which is a function of rents forgone, fixed costs incurred, and operating cost savings. Some also reimburse for extra expenses incurred due to property damage.

3 Historic profit and loss statements, tax returns and rent rolls are used to compute lost profits. But insurers also will factor in macroeconomic trends that may have lowered rental income, even if the disaster hadn t occurred. Because indemnity will be based on your property s financial records, keep your records updated and in a safe location. To make a compensable claim, you must promptly present evidence of lost rental income. You won t be able to recover on properties that weren t generating rental income at the time of the damage. Remember, too, that insurers have taken a beating in recent years, and claims examiners are scrutinizing paperwork harder than ever. Many commercial property owners hire CPA firms to support their lost profits calculations and clarify BI provisions. A caveat Without BI insurance, a damaged rental property could fail before it s ever restored. So, if you re operating without this safety net, consider adding it to your traditional property insurance policy. n A loan primer It pays to know the rules You ve likely noticed that it s difficult to acquire construction loans as opposed to commercial real estate loans. To help you secure the loan you need, it pays to understand your lender s mindset. Here s a primer on how to get the job done. Understand the process Although regular commercial loans are secured by existing cash flow, construction loans are secured by unfinished collateral. The collateral s value depends on the appraised value of land, the project s completion and its estimated economic viability. So, it s natural for lenders to seek assurances that a developer will manage construction risk from project inception. They also want to ensure that developers have enough money invested in the venture to overcome construction problems and make the project succeed. In a tight credit market, lenders evaluating construction loan applications take into account the project s loan-to-value (LTV) ratio. This is calculated by dividing the loan amount by an appraiser s projection of the fair market value of the completed and occupied project multiplied by 100%. Conventional lenders look for an LTV that isn t higher than 75% to 80%. Lenders also want to know the project s loan-to-cost (LTC) ratio. This is the loan amount divided by the total project cost from the time of acquisition to project completion. Because lenders are often 3

4 wary of preconstruction appraisals, they may look to the LTC in their underwriting evaluation. Most want LTC ratios no higher than 80%. Predevelopment project costs include all expenses before construction, such as architectural, engineering, survey, legal and permit work. They can also include land acquisition and demolition costs. Development costs encompass expenses from site preparation through construction, including materials, labor, insurance and taxes. Traditionally, lenders require that the developer have at least 20% equity in the project, which can take the form of free-and-clear land. In today s economy, lenders may require higher contributions from developers and many want personal guarantees as well. Know how numbers are calculated Lenders also scrutinize the project s debt-servicecoverage ratio. This involves calculating net operating income for the completed project to determine if it s sized appropriately for proposed loan payments. The acceptable minimum threshold is 1.25 for multifamily transactions or commercial real estate with at least 60% preleasing to creditworthy anchor tenants. Typically, the debt coverage ratio will be higher for single tenancy, single use properties and multitenant commercial properties. Lenders may require an array of conditions and provisions in the construction and loan documentation to ensure the project is constructed well, within budget and on time. You can also count on your lender to size up your net-worth-to-loan-size ratio. Your net worth should be at least as large as the loan amount. Nowadays lenders are more comfortable in the 1.3 to 1.5 range. Be prepared to provide lenders with information explaining where preconstruction money was spent and the sources for those funds. Lenders look for red flags when sizing up a project. For instance, is land value based on its purchase price or its current market value? If you list the land value as higher than the purchase price due to improvements, expect lenders to scrutinize that claim. A higher value may be justifiable, if the developer assembled several parcels to form the development site, but it won t be justified for costs incurred while demolishing an existing building. Document the details Lenders may require an array of conditions and provisions in the construction and loan documentation to ensure the project is constructed well, within budget and on time. They are likely to negotiate contract time provisions, use of the property, detailed costs, and caps on change orders and cost overruns. But they might also negotiate provisions for dispute resolutions and bonding for contractors. The total package Keep in mind that lenders look for contracts that are assignable to ease completion of the work in case of default. The lender also will scrutinize your experience and history both in the market area and with the type of project being developed, as well as with the financial institution. To ensure your next project gets the funding you need, work with an attorney and CPA who are well versed in construction and real estate matters. n 4

5 SMLLCs: The good, the bad and the ugly Real estate investors are increasingly forming single-member limited liability companies (SMLLCs) to hold properties or interests in partnerships that hold properties and protect themselves from certain liabilities. Part of the attraction lies in the fact that SMLLCs can be classified by the IRS as disregarded entities, meaning they re ignored for income tax purposes. But investors should bear in mind that these entities can produce undesirable tax consequences if they hold partnership interests. Limiting liability SMLLCs are similar to corporations in that they limit owners personal liability for the debts and actions of the entity. Creditors of the SMLLC can t go after investors personal assets; they can pursue only SMLLC assets. As a result, an investor can t lose more than it invests. Investors with more than one property can also use multiple SMLLCs to segregate potential liability exposure for each property. SMLLCs also offer some of the benefits of partnerships, without requiring at least two parties. For example, they provide management flexibility and the advantages of flow-through taxation to the owner. This often isn t desirable because it can result in double taxation for instance, if the SMLLC is treated as a C corporation, it s taxed on income it generates, and then the single member/owner is taxed on any dividends he or she receives. If, on the other hand, the SMLLC elects to be treated as an S corporation (a flow-through entity), double taxation is avoided. In such a case, though, the single member/owner will be subject to tax on all of the S corporation s earnings, typically through a combination of salary and flow-through income. While S corporations generally aren t taxed at the federal level, state tax could be imposed. If an SMLLC doesn t elect to be a corporation, the IRS will classify it as a disregarded entity taxed as a sole proprietor. The single member/ owner reports all of the entity s income, gains, losses and expenses on his or her own tax return. The entity doesn t file a tax return, thus avoiding double taxation. Federal tax treatment For federal income tax purposes, an SMLLC can be treated as either a corporation or a single-member disregarded entity. To be treated as a corporation, the SMLLC must file IRS Form 8832 and elect to be classified as a corporation. 5

6 Dealing with other taxes While single-member limited liability companies (SMLLCs) treated as S corporations or disregarded entities generally avoid federal income tax liability (see main article), they may be subject to other taxes. Although many states apply the federal income tax scheme to LLCs (including SMLLCs), some, such as Texas and California, impose additional taxes and fees on these entities. SMLLCs are also subject to property, sales and excise taxes where applicable. And your SMLLC will have to deal with employment taxes if you employ others. Finally, as owner, you d be treated as self-employed for employment tax purposes and, therefore, be subject to self-employment taxes on your net self-employment earnings. Partnership-related risks If you re considering using an SMLLC to own a partnership interest, be aware of these potentially negative tax repercussions that wouldn t necessarily be the same if you were to own the partnership interest as an individual: Partnership losses. Real estate investors know that they re likely to incur losses in the early stages of a real estate development. The amount of losses depends on factors such as the amount of deductible depreciation, the size of the project s debt and the building s occupancy rate. If your losses exceed the amount of equity invested and you ve invested directly in a partnership, you generally can deduct the losses up to the amount of the equity investment plus your allocable share of any partnership liabilities. Losses are deductible on your personal tax return, although some losses could be suspended for use in future years. The IRS also allows you additional tax basis for the share of liabilities that you ll ultimately be responsible for as a partner, regardless of whether you have adequate assets to pay those liabilities. But if you establish an SMLLC, allowable losses are limited to the amount for which you re personally responsible. So, unless you ve personally guaranteed the SMLLC debts, you re allowed additional tax basis only for the partnership s liabilities up to the fair market value of the SMLLC s assets. Also, your losses from the partnership are deductible only up to your equity investment in the SMLLC plus the fair market value of other assets owned by the SMLLC. Taxable gains on contribution. If you ve claimed tax losses that exceed your equity investment in a partnership and you no longer have allocable liabilities from the partnership contribution of the partnership interest to an SMLLC can produce a taxable gain. Distributions in excess of equity. Normally, you can take distributions out of a partnership up to the amount of your tax basis without causing a taxable gain. Your tax basis equals your equity investment plus allocable liabilities adjusted for earnings and losses of the partnership and prior distributions. If the partnership interest is held by an SMLLC, though, the allowable distribution may be significantly more restricted. Making the decision Although some negative tax issues may be avoided by electing corporate status, there are other considerations as well. Your financial advisor can help you determine the best route for your circumstances and objectives. n 6

7 Ask the Advisor How can I build a better loan request package? The tight credit markets show few signs of easing significantly anytime soon. With financing difficult to obtain, you might have only one shot with a lender. So the most effective way of increasing your odds is to submit a solid loan request package. Helping the lender help you Today s lenders and underwriters expect a mountain of documentation before they ll approve your loan. Take note of extra documents your lender needs and submit a complete loan request package. Packages that lack information or are difficult to sort through will likely end up behind the more complete and organized ones. Plus, lenders are more likely to push through the loans that require the least amount of work. Savvy borrowers know that a complete package is also a sales tool. After all, you want to sell the lender on your project and its funding. A well-thought-out loan request package conveys the image of a strong and prepared project manager who will stay on top of the project. Including essential components Items included in a loan request package vary by lender, and each lender will likely add some special requests. In general, though, plan to include the following in your request package: n A specific loan request with the desired amount, term and amortization schedule, n The address and description of the property, including photos of the property, the date and type of construction, and details such as the type of property management, n The legal name of the ownership entity, including each partner s percentage ownership, n The current rent schedule, including tenants, square footage, move-in dates, rent, escalation clauses and expiration dates, n Physical occupancy and rent collections for the previous 12 months, including delinquencies, n Balance sheets and profit-and-loss statements for the last five years, with explanations of any significant movement in income or expenses, n The year and amount of the most recent acquisition of the property, n A description of major improvements made in the past five years, and n A list of environmental issues and immediate repairs. If applicable, provide a copy of the most recent appraisal, rent comparables for the area and a copy of the standard lease(s). Some lenders also ask for financial statements from your anchor tenants, owners personal financial statements, proof of insurance, business plans and forecasts, and market feasibility studies for loans used in development or remodeling. Going forward Once you ve assembled the necessary information, make copies to keep on hand. With a little tweaking, you ll be ready to go for future loan requests. n This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use REAma12 7

8 Mount Arlington Office Newton Office Welcome to the inaugural issue of the Real Estate Advisor, a quarterly newsletter designed to provide real estate developers, property owners and managers with information about ways to reduce costs, minimize taxes and maximize profit. To remain competitive today, you must rely on your ability to plan for and respond to the dynamics of the industry. Forecasting new trends in commercial development and monitoring population shifts as well as managing costs and maximizing revenues must all align for success. You may also require more than a traditional accounting and tax services firm. Established in 1970, we have proudly earned a reputation for integrity, personal service and dependability. Our years of experience coupled with our specializations enable us to fully understand our client s needs and provide the most beneficial solutions and advice. As a firm, we have over 30 years of experience servicing clients in the real estate and construction contractors sectors. Both Nick Sarinelli and I have over 20 years individually in these industries and have the expertise to advise on all aspects of the business. Please visit our Web site, for additional information about our firm and the services we provide. We hope you enjoy this and future issues of the Real Estate Advisor, and find it helpful in achieving your business and financial objectives. Please do not hesitate to call if you have a question regarding one of the articles, or you would like additional information regarding an accounting or tax issue. Sincerely, Douglas S. Collins, CPA, Partner Dominick J. Sarinelli, CPA, CFE, Partner Nisivoccia LLP Real Estate Development and Contractors Group Mount Arlington Office Newton Office