Commercial real estate is defined as investment property that is acquired with the intent to earn a return through cash flow, price appreciation, or both. The primary difference between a commercial investment property and a residential investment property is that commercial property tenants are businesses, not individuals (with the exception of multifamily).
Because there are a number of complexities associated with acquiring and operating a commercial property investment (as opposed to a residential property), there are a variety of loan products designed to meet the needs of commercial borrowers. In this article, five of the most common loan options are reviewed: Term Loans, Bridge Loans, Construction Loans, Lines of Credit, and Hard Money Loans.
Loan Type #1: Commercial Term Loans
A “term” loan is what many think of as a traditional bank loan. It is similar to a residential mortgage in the sense that the loan proceeds are advanced in a lump sum at closing and repaid with monthly installments of principal and interest. In many cases, a term loan has a fixed interest rate, which also results in a fixed payment that does not change over the life of the loan.
Unlike residential mortgages, commercial term loans are unlikely to be fully amortizing. Commercial mortgages typically have a term of 5-10 years and payments are usually based on a 20-25 year amortization period. This means that there will be an outstanding balance at the end of the loan term that must be retired via a “balloon payment.”
Approval requirements for a term loan vary by lender, but they typically require a 10% – 25% down payment, good credit score, strong collateral, and experienced loan sponsors.
The benefits of a term loan are the fixed rate and fixed monthly payments that consist of principal and interest. However, the fixed rate exposes the borrower to some interest rate risk. If rates were to fall below the fixed rate, the borrower could end up paying more than is necessary.
Term loans are best for stable, cash flow positive properties that are going to be held for at least 5-10 years.
Loan Type #2: Bridge Loans
A bridge loan is just what its name implies. It is a short term loan designed to “bridge” the gap between property acquisition and stabilization. Bridge loans are particularly common for properties that have a renovation or value-add component. In addition, they are useful for properties that have a high rate of vacancy at the time of acquisition. In either case, the property is acquired with a short term bridge loan and renovations or lease-up are completed to stabilize the property, at which point the bridge loan can be paid off with a conventional term loan.
Because of their short term nature and higher risk profile, bridge loans have a higher interest rate than term loans. The exact interest rate depends on the creditworthiness of the borrower and the strength of the collateral, but it is usually .50% to 1% higher than a term loan rate.
The benefit of a bridge loan is that they allow an investor to purchase a property and get to work improving it. But the higher rate makes them more expensive and there is always a risk that the property improvements won’t go as planned leading to difficulty refinancing.
Loan Type #3: Construction Loans
A construction loan is also a short term facility, but its funds are used to finance the construction of a property from the ground up. These loans are most appropriate for developers seeking financing for a new project.
The defining characteristic of a construction loan is that loan proceeds are not advanced in full at the time of closing. Instead, they are advanced in stages or “draws” in accordance with an approved construction budget. In addition, the loan usually has a pre-funded interest reserve account from which loan payments are made during the construction phase. Once construction is complete, the construction loan is repaid by a permanent loan or refinance.
The term and loan amount for a construction loan are dependent upon how long it will take to construct the property, usually 12-24 months, and how expensive it will be to build.
The benefit of a construction loan is that they usually have interest only payments during the construction period and these payments are funded by the interest reserve account. But, there is a non-material amount of execution risk that could impact repayment of the facility. For example, suppose that a winter storm hits and delays construction for 2 weeks. These types of delays can result in added interest expense. For these reasons, developers always build some amount of contingency into their timelines.
Loan Type #4: Line of Credit
A Line of Credit, sometimes called a “Guidance Line of Credit” is typically reserved for the most active and well funded borrowers. With this loan program, developers with multiple projects can get approved by a commercial lender for one large amount, say $10M, and then use this credit limit to fund the acquisition of multiple properties under individual “advances” under the credit line. Each advance has established approval criteria like a maximum loan to value (LTV), debt service coverage ratio (DSCR), and loan to cost.
The benefit of a guidance line of credit is that it allows borrowers to move quickly to acquire the best properties and it saves them money on closing costs because they only have to close on one big loan, not several smaller ones. However, each advance may have a “term limit” which means that it has to be repaid within a certain amount of time. Usually repayment comes in the form of a property sale or loan refinance.
Loan #5: Hard Money Loan
Finally, a hard money loan is one made by private investors and the amount is based on the value of the property, not the strength of the borrowers.
Of the types of commercial real estate loans listed in this article, a hard money loan is the most expensive and carries the most risk. It should only be used by experienced borrowers who fully understand the cost and risk associated with it. They are really only appropriate as a last resort or if they are going to be used as short term financing before refinancing into a longer term, lower cost loan.
Approval criteria for hard money loans are less stringent than conventional loans because they are based on the property, not the borrower. So, real estate investors with low credit scores or a history of financial issues may turn to this option.
Final Thoughts
No matter the project or property that needs to be financed, financial institutions offer a variety of loan products to meet the needs of small business owners and other real estate borrowers. To determine which option is best, investors should work with bankers and financial institutions to review the available options and decide upon the best fit.
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 learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
