Protecting Your Income with Business Interruption Insurance

The past decade or so has highlighted the need for commercial real estate owners to 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 unable to generate their usual levels of income. Business interruption (BI) insurance can help you augment your income stream for the period when tenants can’t fully use their space or when you’re unable to fully conduct business at the property. BI 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 essential in risk management planning. How it Works BI insurance compensates a company for lost income when the company must suspend normal operations because of physical damage to property or a civil order requiring the business to close. While property insurance covers only physical damage to your property, BI insurance provides cash flow to pay property expenses, including debt service, which continue to be incurred even though the property might not be in use. 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 business interruption. Policy terms vary greatly. A policy may prescribe a specific period of recovery, a maximum period of coverage or a maximum recovery per month. Companies can obtain extended coverage for the period between the completion of repairs and the property’s 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 those partly due to a slow rental market. How Lost Income is Computed BI insurance aims to make commercial property owners “whole” after a disaster. Policies compensate for lost income, a function of rents forgone during the time the building is not in use by tenants, as well as fixed costs incurred less operating cost savings. Some policies also reimburse for extra expenses incurred due to property damage. Historic profit and loss statements, tax returns and rent rolls are used to compute lost profits. 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 the 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 help them gather support for their lost profits calculations and to 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.

A Construction Loan Primer: It Pays to Know the Lender's Rules

Understand the Process In these uncertain economic times, it’s more difficult to obtain 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. Know How the Numbers Are Calculated While 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 the underlying land, the project’s stage of completion and its estimated economic viability. It’s natural for lenders to seek assurances that a developer will manage construction risk from project inception. Lenders also want to ensure that developers have enough money invested in the venture so there’s an economic incentive for the developer to provide all of the “sweat-equity” needed to 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. Typically, conventional lenders look for an LTV that is not more 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 costs from the time of acquisition to project completion. Total project costs include pre-development and development costs. Pre-development project costs include all expenses before construction, such as architectural, engineering, survey, legal and permit work, as well as land acquisition and demolition costs. Development costs encompass expenses from site preparation through construction, including materials, labor, insurance, utilities and taxes. Because lenders are often wary of preconstruction appraisals, they may look to the LTC ratio in their underwriting evaluation. Most lenders want LTC ratios no higher than 80%. Traditionally, lenders require that the developer have at least 20% equity in the project which can take the form of a contribution of free-and-clear land. In today’s economy, lenders may require even higher contributions from developers — and many want personal guarantees as well. Lenders also scrutinize the project’s debt-service-coverage ratio (DSC). This involves calculating projected net operating income for the completed project to determine if it’s sized appropriately for the proposed loan payments. The minimum acceptable DSC ratio is generally 1.25 for multi-family housing or commercial real estate that is at least 60% pre-leased to creditworthy tenants. Typically, the DSC ratio required will be higher for single tenancy properties and multi-tenant commercial properties. You can also count on your lender to size up your net-worth-to-loan-size ratio. Lenders look for net worth to be at least equal to 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 provisions for completion deadlines, use of the property, detailed costs, and caps on change orders and cost overruns. They might also negotiate provisions for dispute resolutions and bonding for contractors. The Total Package Lenders often request construction contracts that are assignable to facilitate completion of the work in the event of default. The lender will also scrutinize the developer’s experience and history — both in the market area and with the type of project being developed, and with previous lenders. 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.

Ask the Advisor

How Can I Build a Better Loan Request Package? The tight credit markets show few signs of easing significantly in the near-term. With financing difficult to obtain, a borrower might have only one shot with a lender. Loan request packages that lack information or are difficult to sort through will likely end up behind the more complete and organized ones. One of the most effective ways of increasing the odds of getting loan approval 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. 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. Be prepared and start gathering the documentation that lenders will need as soon as you decide to seek financing. Essential Documentation Documents 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 loan request package:

    • A specific loan request with the desired amount, term and amortization schedule,
    • 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,
    • The legal name of the ownership entity, type of entity and each owner’s percentage interest,
    • The current rent schedule, including tenants, square footage, move-in dates, rent, escalation clauses, extension options, landlord work allowances and expiration dates,
    • Historical occupancy levels and rent collections for the previous 12 months, including delinquencies,
    • Balance sheets and profit-and-loss statements for the last five years, with explanations of any significant variances in income or expenses,
    • The date and amount of the purchase price of the property,
    • A description of major improvements made in the past five years, and
    • A list of environmental issues and immediate repairs needed.

If available, provide a copy of the most recent appraisal, rent comparables for the area and a copy of your 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.

For Futher Information

If you have any questions, please contact William Jennings, Partner-in-Charge of the Real Estate Services Group at 212.503.8958 or wjennings@markspaneth.com or any of the other partners in the Marks Paneth Real Estate Services Group:

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Treasury Regulations require us to inform you that any Federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © Marks Paneth LLP 2012 MANHATTAN | LONG ISLAND | WESTCHESTER | CAYMAN ISLANDS