Selling Your B&B? How Much Can Your Borrower Borrow?

Thinking of Selling? How Much Can Your Buyer Borrow?

Let your mind roam ahead in time for a moment. You have put your B&B on the market and you now have an offer. The buyer is going to apply for a mortgage. What do you have to sell? To a lender, you are selling first an income stream. The most critical items for any lender in any commercial loan application package are the financial items - business financial statements and business tax returns (three years for both). These items are always required, so it is in your best interest to have them complete, current and ready. You also need to provide interim financial statements current to within 90 days - income statement and balance sheet, because the lender will require it.

To a Lender, Cash Is King

You are familiar with the old saying that "cash is king." In our context, that is, to a mortgage lender, it means the amount of cash generated from a business that can be used to pay a mortgage. Many people mistakenly think that net income is cash flow, but it is not. Net income does not tell you how much cash is generated by the business. It is the net operating income, or NOI. This is simply the gross income minus all operating expenses - the cash flow.

Generally there are three items on business tax returns that a lender uses to determine the cash flow available to pay the mortgage. They are net income, interest and depreciation. The cash generated by a business is the only number that can be used to determine how much mortgage a business will support. Lenders want a certain amount of cushion when looking at how much cash there is available for loan payments, on the assumption that if there is a temporary slowdown in business, the cash flow will not be so tight that there is not any cushion to still make the loan payments. Usually this is expressed by the term debt coverage ratio. That means that if, for example, the mortgage payment is $1, a lender may want to see $1.25 in cash flow available to make the $1 payment. This is not an automatic rule. Different types of lenders may have slightly different requirements and often the higher the risk perceived by the lender, the higher the required debt coverage ratio.

This does not mean that other things are not important, such as revenue and income trends, collateral value, borrower's credit history, etc. But if there is not sufficient cash flow to support a mortgage, the rest usually doesn't matter.

How Is Value Determined?

Now let's go back to the NOI and its relationship to value. In commercial appraising, value is established using a combination of three approaches - the income capitalization approach, the cost approach and the sales comparison approach. In the income capitalization approach, the NOI is converted into a value by means of the capitalization process. To illustrate the in the simplest possible way, suppose you are going to buy an investment and you want to earn at least 10% on your invested capital. That 10% is your capitalization rate, which you will use as a means of determining value. If you are offered an investment that has an income to you of $1,000, you would be willing to pay $10,000 for that investment because it would give you a 10% return, or $1,000 a year. Your capitalization rate has set the value. It is the same with an inn.

The cost approach is the least accurate way to establish a value. For existing inns, the cost approach is almost meaningless. For example, to apply the cost approach in an appraisal of a 1790 brick Federal-style inn would be a waste of time because it would cost a fortune to reproduce faithfully, and would be highly unlikely to be sold as a business at that price.

The sales comparison approach can be more useful, but it has its own built-in set of limitations. The farther apart geographically the sales comparables are that an appraiser can find, the less relevant they become. It's one thing to compare a 56-room Sleep Inn in one state with a 56-room Sleep Inn in an adjacent state because the physical facilities are identical and the room rates are similar because it is a franchise. But to compare a nine-room inn in the mountains with a nine-room inn near the sea coast is not truly accurate.

This leads us to the final question. If your buyer cannot borrow enough that combined with their down payment meets the asking price, then what? The only way to make your sale is that you may have to hold a second mortgage. Hardly anyone ever wants to do that, but in today's financing environment, and probably into 2009 or 2010, that may be your only choice. And if the borrower can get an SBA loan, that second will have to be on full stand by, which means that the borrower cannot make payments (interest can accumulate) until the loan is paid off.

In conclusion, if you plan to put your inn on the market in the next two or three years, don't expect it to be easy. Most of the residential lenders who have provided a lot of financing have "left the building." Only the strongest deals are going to get serious consideration including in most cases, a buyer with some kind of lodging industry experience.