Protecting your income with business interruption insuranceA loan primerIt pays to know the rules

SMLLCs: The good, the bad and the ugly

Ask the AdvisorHow can I build a better loan request package?

Real Estate advisor

March • April 2012

www.elliottdavis.com

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The past decade or so has highlighted the need for commercial real estate owners to obtain and maintain appropriate insur-

ance 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 worksBI 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.

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 prop-erty 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.

How lost income is computedBI insurance aims to make commercial prop-erty 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.

Protecting your income with business interruption insurance

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.

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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 processAlthough 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 assur-ances that a developer will manage construc-tion 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 con-struction 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

A loan primerIt pays to know the rules

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 calcula-tions and clarify BI provisions.

A caveatWithout 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

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, engi-neering, 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 contribu-tions from developers — and many want personal guarantees as well.

Know how numbers are calculatedLenders also scrutinize the project’s debt-service- coverage 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.

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 lend-ers 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 detailsLenders may require an array of conditions and provisions in the construction and loan docu-mentation 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 packageKeep 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

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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.

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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 attrac-tion 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 partner-ship interests.

Limiting liabilitySMLLCs 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 inves-tor 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.

Federal tax treatmentFor federal income tax pur-poses, an SMLLC can be treated as either a corporation or a single-member disregarded entity. To be treated as a cor-poration, the SMLLC must file IRS Form 8832 and elect to be classified as a corporation.

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 earn-ings, 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.

SMLLCs: The good, the bad and the ugly

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Partnership-related risksIf you’re considering using an SMLLC to own a partnership interest, be aware of these potentially negative tax repercussions that wouldn’t necessar-ily 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 proj-ect’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 lia-bilities. 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 guaran-teed 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 decisionAlthough some negative tax issues may be avoided by electing corporate status, there are other consid-erations as well. Your financial advisor can help you determine the best route for your circumstances and objectives. n

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 addi-tional 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.

Dealing with other taxes

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. ©2012 REAma12

How can I build a better loan request package?

Ask the Advisor

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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 youToday’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 com-plete 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 componentsItems 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 forwardOnce 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

In the real estate industry, the numbers are big and so are the risks. Poor timing, bad advice, even small oversights can have substantial consequences. Whether you’re a developer or an investor, Elliott Davis’ Real Estate Practice helps keep your business grounded.

Our team puts its deep industry knowledge and experience to work for you with customized solutions based on your specific situation and requirements. With our network of locations throughout the Southeast we deliver personalized service wherever your business lands.

ACCOUNTING SERVICES:Our team reviews your historical financial statements, evaluates trends, and pinpoints strengths and weaknesses in your financial and operational business performance. We make certain you’re receiving the right kind of financial information to run your business and ensure tax compliance. We provide not only traditional credit, review compilation, and tax preparation services but also forecasts, projections and acquisition evaluation and accounting.

BUSINESS ADVISORY SERVICES:Our Real Estate Practice helps you consider and structure various alternatives to maximize return on investment. A sampling of our services include: 1031 exchange consulting, cost segregation studies, revenue recognition and cost allocation techniques, tax credits, and business entity planning and organization choice.

With offices located throughout the Southeast, members of the Elliott Davis Real Estate Practice can respond quickly to their clients’ needs. Please contact us at 1-877-340-6802 to tell us your real estate goals and learn how we can help you achieve those goals, or visit us online at www.elliottdavis.com for more information.

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