Commercial real estate assets are expensive with prices often running into the tens or hundreds of millions of dollars. As such, they are unlikely to be purchased with cash. Instead, investors often purchase real estate investments with equity (cash) and debt in a mix referred to as the “capital stack.”
In this article, we are going to discuss the most common options for financing a commercial real estate investment. In doing so, we will describe what they are, how they work, and the pros and cons of each. By the end, investors will have a more thorough understanding of each real estate financing option and will be able to incorporate this information into their pre-purchase due diligence process.
At First National Realty Partners, we are a private equity firm who specializes in the purchase and management of grocery store anchored retail centers. If you are an accredited investor, interested in partnering with a private equity firm to allocate capital to a commercial real estate investment, click here.
What is the Capital Stack?
The term “Capital Stack” refers to the mix of capital used to finance the purchase of an investment property. Although every deal is unique, there can be up to four components:
1. Common Equity
Equity is the cash injected into a property. An easy way to think about it is as the down payment on the property. The money may come from one or more investors and an equity position entitles them to their proportionate share of the cash flow and profits produced by the property. Equity holders are last in line to be repaid so they typically demand the highest return because it is the riskiest position.
2. Preferred Equity
Preferred equity is very similar to common equity, but there is one key difference. As the name suggests, preferred equity holders have priority over common equity holders when it comes to repayment. Often they are paid a “preferred return” as an incentive for taking this position.
3. Mezzanine Debt
Mezzanine debt is a type of loan made to real estate investors that is meant to fill the difference between the senior loan amount and the amount of equity raised. For example, if a property had a purchase price of $10M and a senior loan of $7M. If the investor was only able to raise $2.5M in equity, they may need $500,000 in mezzanine debt to make up the difference. Mezzanine debt holders are secured by an interest in the property’s ownership entity and are second in line for repayment, behind senior debt holders.
4. Senior Debt
Senior debt is a loan and typically makes up the largest portion of the capital stack, usually somewhere in the 50% – 80% range. Senior debt holders are first in line to be repaid so it is considered to be the least risky position.
Capital Stack Example
To illustrate how the repayment order works, consider an example of a property that earns $100,000 in net operating income. From that amount, senior debt holders get paid first, assume it is $70,000. Now, there is $30,000 left over and $10,000 goes to mezzanine debt holders, $15,000 goes to preferred equity holders and the remaining $5,000 would go to common equity holders.
When the property is operating normally and there is enough money to pay everyone, there are no issues. However, it can get very tricky when there is a decline in rental income and there is not enough money to go around, the repayment order becomes very important because it is possible that some may not get paid.
Because senior debt is usually the largest portion of the capital stack, the remainder of this article will focus on the senior debt options available to investors.
Commercial Debt vs. Residential Debt
There are two notable differences between commercial and residential debt.
The first one is obvious, commercial debt is used to purchase commercial properties while residential debt is used to purchase residential properties, single family or multi family with less than 4 units, that can be used either as a primary residence or rental property.
The second notable difference is less obvious. Commercial loans are far more complex and lenders have far more flexibility when negotiating their terms. For example, they can customize the interest rate, amortization schedule, or loan covenants to fit the needs of the borrower in a given transaction. Conventional loans on the residential side are much more structured and the terms and conditions are fairly consistent for all borrowers.
When creating a financial model for a transaction, it is important to understand the nuances of the debt that will be used in the transaction because they can have a major impact on potential returns. For the purposes of this article, the focus is on commercial debt.
Who Are Commercial Real Estate Lenders?
For many real estate investors, obtaining the right debt is one of the most challenging aspects of a transaction. By “right” debt, we mean a loan with terms and conditions that contribute to a profitable outcome in the transaction.
To find the right deal, borrowers could turn to one or more of the following types of commercial lenders:
The first and most obvious choice for many investors is to get a traditional retail bank loan. Depending on the size of the need, the bank can range in size from a small community bank or credit union to one that has a global presence. In general, the larger the loan amount needed, the larger the bank that needs to be involved.
The benefit to working with a traditional bank is that there are many different options. The major downside is that they are likely to require a personal guarantee, which can raise the stakes of the deal for the individuals involved in the transaction.
It may seem counterintuitive, but most major insurance companies have a lending operation. For example, Pacific Life offers a variety of loan products to meet a borrower’s needs.
The benefit of working with an insurance company is that the terms are generally very favorable for borrowers. For example, they often have a lower interest rate, a fixed rate, lower down payment requirement, or lower closing costs. In addition, many of these loans are non-recourse, meaning they do not require a personal guarantee. The downside is that insurance companies are very selective and they typically only work with the largest, safest, most stable properties. As such, it can be difficult to qualify.
There are a number of government agencies that make commercial real estate loans directly or guarantee them through a variety of programs. For example, the Small Business Administration (SBA) makes commercial real estate loans through their SBA 7 and SBA 504 programs. Fannie Mae (FNMA), Freddie Mac (FHLMC), Housing and Urban Development (HUD), and the United States Department of Agriculture (USDA) are also active lenders in the multifamily space with a mission to help provide more affordable housing.
Again, the major benefit of working with a government agency is that they typically provide favorable terms and do not require a personal guarantee. The downside is that there is little flexibility with these programs and borrowers may have to navigate typical government bureaucracy to get an approval, which is to say it can take some time.
Hard Money Lenders
Hard money lenders are private money lenders who base their credit decision on the perceived value of the property, not the creditworthiness of the borrower.
The benefit of getting one of these private money loans is that approval decisions are less strict, which makes them good for new investors or those with a checkered credit history, and can often be made very quickly. But, hard money loans also come with higher interest rates and high up front fees so they are not usually the most cost effective option. For this reason, they are commonly used as temporary solutions or “bridge loans” to acquire and stabilize a property. Ultimately they are repaid by a permanent loan or sale.
Pension funds are retirement plans into which employees of a company, union, or government deposit money. Fund managers are responsible for deploying the plan’s assets into investments that will earn a return. Often, this includes debt investments.
The benefit of getting a loan from a pension fund is that they also usually have favorable terms when compared to other marketplace lenders. Like insurance companies, the downside to working with a pension fund is that they are typically very risk averse, meaning they have very strict approval criteria.
Hedge Funds & Private Equity Firms
Like Pension Funds, Hedge Funds and Private Equity Firms are responsible for deploying fund assets into investments that earn a return for their shareholders. Depending on the objectives of the fund, some of these funds may be deployed into debt.
Hedge funds may also have generous approval criteria and may be more willing to take risk than more traditional financial institutions. But borrowers will pay for this in the form of higher interest rates and higher fees, especially on the front end of the loan.
Finally, one option that is often overlooked is that financing could come from the seller of the property. There are a variety of reasons why they would do this, but they most often come back to the idea that they want the income and interest from the debt.
Seller financing, also called owner financing, can certainly make the transaction much easier in the sense that a borrower does not have to go through all of the work to get approved for a more conventional mortgage. But, the downside is that this is more the exception than the norm – most sellers prefer to sell the property outright.
How Real Estate Investors Can Obtain Financing
Think of lenders as investors, but instead of investing in a property, they are investing in debt. So, it is safe to say that they also have their own preferred loan types, risk tolerance, and time horizons. For this reason, it can be tough to get a loan to finance a real estate investment because the approval criteria can vary widely from one lender to another.
So, to have the greatest chance of approval, it is a best practice for potential borrowers to take stock of their own deal and then to look for lenders who like loans with a similar profile. Often, it may take approaching several lenders before finding one that is willing to approve the loan.
Key Commercial Real Estate Loan Terms and Approval Criteria
To both understand what a lender is looking for in a deal and to be able to model the transaction, it is important to understand the key terms and conditions typically involved in a commercial real estate loan. The biggest ones are highlighted below:
Loan to Value (LTV)
Most lenders have a maximum percentage of the property’s value they are willing to lend. The exact percentage varies by lender and property type, but it is generally within the range of 75% – 80%. For land, the maximum loan may be as low as 50%. For single occupant properties with credit tenants, it may be as high as 95%. .
Debt Service Coverage Ratio (DSCR)
The DSCR is the ratio of a property’s Net Operating Income (NOI) to its loan payment. Many lenders have a minimum that must be met. Again, it varies by lender and property type, but it is generally around 1.25X.
To secure their loan, most lenders want a high quality piece of collateral, meaning that it is in a good location and they wouldn’t have any difficulty selling it in a foreclosure situation. For many lenders, this means that they won’t loan against riskier property types like hotels, restaurants, or raw land.
The borrower in a commercial real estate transaction is usually an operating company or a single purpose entity. They are the party legally responsible for repayment of the loan.
Some lenders require the personal guarantee of the individuals acting as the loan sponsors. This means that they are personally responsible for repaying the loan if the deal goes bad.
Sources of Repayment
When evaluating a loan request, each lender will seek to identify up to three sources of repayment. In most cases, the primary source of repayment is the cash flow produced by the property. The secondary source of repayment is the sale of the property. And, the third source of repayment is the recourse to the guarantor(s).
Most loans have a defined term for their loans. If the loan is paid off before the end of the term, there may be a penalty for doing so.
Each lender will pull a credit report for each of the individuals on the loan application. If their credit score does not meet some minimum requirement, this may impact their eligibility.
The number of months over which the monthly payments are calculated. For commercial mortgages, it is common to have a different loan term and amortization. For example, the loan could have a five year term and the payment could be based on a 20 year amortization. In this structure, there is a “balloon payment” at the end of the term.
Once investors have familiarized themselves with key terms, they can begin the application process and choose a specific loan type.
Commercial Real Estate Loan Types
Broadly, there are two types of commercial real estate loans: open and closed end.
An open-end loan is one where the amount of credit can be used repeatedly. The most common open-end loan type is a line of credit where funds are advanced and repaid over and over as they are needed by the borrower. These are fairly rare in commercial real estate, but they are offered from time to time under the right circumstances. For example, one common open ended loan is a “homebuilder line of credit” which is used by residential home builders to buy lots and build spec or pre-sold homes.
Closed-end mortgage loans are much more common. These are sometimes referred to as “term loans” where the loan amount is advanced and repaid in installments over time. These are typically used in purchase and refinance transactions.
Within these two categories, there are many different loan products designed to meet the diverse needs of business owners and commercial real estate borrowers. For example, lenders may have special loan programs for the purchase or renovation of multifamily assets or have special facilities for the ground up construction of a new property.
What is the Best Way to Finance a Real Estate Investment?
There is no “best” way to finance a commercial real estate investment. Because every transaction is unique, the “best” option is the one that is the best fit for the circumstances of the deal and the overall investment strategy. To find this, investors should take the following steps:
Understand What The Deal Needs
The most important step to finding the best fit is having a good idea of the terms that are best for the transaction. Often, this means creating a proforma financial model and running different loan scenarios to see which one provides the best return. The different scenarios can include different interest rates, amortization periods, or payment structures. The changes in the commercial mortgage payments can have a dramatic impact on returns.
Finder a Lender
Once an investor has a good sense for the most optimal structure, the next step is to find a commercial mortgage lender who has a loan product that has a profile similar to the one that is needed.
Negotiate The Deal
It is rare for borrowers to get everything they want in a deal. So, they have to negotiate with the lender to try and get as much of what they want as they can. In a good negotiation, both the lender and the borrower walk away happy.
Once the deal is negotiated, the final step is to close it. From application to closing, it can often take 60-90 days so the borrower should prepare accordingly.
Financing Real Estate Investments & Private Equity Real Estate
As this article described, the process of financing a commercial property purchase can be incredibly complicated, on both the debt and equity side. For an investor looking to manage their own real estate deal, this can be a tremendous amount of work. So, a compelling alternative is to partner with a private equity firm, for two reasons.
First, the private equity firm handles the logistics of financing the purchase, meaning that they leverage their relationships and expertise to arrange both the equity and the debt needed to get the deal closed. For individual investors, this can be a major relief.
Second, and perhaps more importantly, the private equity firm can leverage their resources to get the most suitable deal for the transaction. By resources, we mean their expertise to get the most favorable terms and their financial resources to ensure that the deal gets approved quickly and easily.
With this approach, working with a private equity firm is kind of a turnkey solution for investors. The firm handles everything, including property management, and all the investor has to do is sit back and collect their passive income.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To finance all of our transactions, we use a combination of debt and equity to maximize the chance for high returns.
To learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.