One of the major benefits of commercial real estate investment is the wide availability of debt financing options at generally favorable terms. However, it is easy for investors to be overwhelmed by the number of options, the unique terminology, and the differences in loan approval requirements by lenders. These topics are the subject of this article.
Commercial Real Estate Loans – Defined
A commercial real estate loan is one that is secured by a mortgage on a commercial property. A commercial property is one that produces income and is used for business purposes. Generally, there are four widely recognized commercial property asset classes:
- Multifamily (> 5 units)
A commercial real estate loan can be obtained to purchase, construct, or renovate any of these property types. In most cases, the loan borrower falls into one of two categories: an operating business who needs the property for their own account or a single purpose entity formed specifically for the purpose of the transaction.
Commercial Real Estate Lenders
Depending on the property type and loan amount, there are a variety of commercial lenders from which a loan can be obtained:
- Banks: 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.
- Insurance Companies: 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. In many cases, these loans are restricted to the largest and highest quality properties so it can be difficult to qualify.
- Government Agencies: 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. Or, Fannie Mae (FNMA), Freddie Mac (FHLMC), Housing and Urban Development (HUD), and the United States Department of Agriculture (USDA) are active lenders in the multifamily space with a mission to help provide more affordable housing.
- Hard Money Lenders: Hard money lenders base their credit decision on the perceived value of the property, not the creditworthiness of the borrower. But, hard money loans come with higher interest rates and high up front fees and are not 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: 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.
- 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.
Unless an investor has an existing relationship, they tend to be lender agnostic. This means that they will work with whomever is willing to lend them money at the most favorable terms. For this reason, it is important to understand key terms and approval criteria used to evaluate a commercial real estate loan request.
Key Commercial Real Estate Loan Terms and Approval Criteria
The process of getting a commercial real estate (CRE) loan requires the understanding of key terms and acronyms that may be unfamiliar to first time borrowers. They include:
- 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%. The difference between the loan amount and the purchase price is the required down payment.
- 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.
- Collateral: 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.
- Borrower: 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.
- Guarantor: 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).
- Prepayment Penalties: 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.
- Credit Score: 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.
- Amortization: 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.
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.
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 email@example.com for more information.