Our commercial real estate deals are not closed unless the loan is approved. You can also increase cash flow if the interest rate on the loan is low. So, the more you know about commercial loans, the better decisions you can make about your commercial real estate investments.
Loan Qualification: Most of you have applied for a housing loan and are familiar with the process. You provide to the lender by:
W2 and/or tax returns so you can verify your income,
Bank and/or brokerage statements so you can verify your liquid assets and down payment.
In general, the more personal income you generate, the higher the number of eligible loans. You can even borrow 95% of the purchase price for 1 main house unit with sufficient income.
For commercial loans, the loan amount the lender will approve is based primarily on the net operating income (NOI) of the property, not your personal income. This is the basic difference between eligible residential and commercial loans. Therefore, if you buy a vacant commercial building, you will have a hard time getting loan approval because the property has no rental income. However, if you
Occupies at least 51% of the space for your business; You can apply for an SBA loan.
Have sufficient income from other commercial properties that are used as cross collateral; there are lenders out there who want your business.
Loan to Value: Commercial lenders tend to be more conservative about loan to value (LTV). Lenders will only lend you an amount such that the NOI-to-mortgage ratio for the loan, called the Debt Coverage Ratio (DCR) or Debt Service Ratio (DSR) must be at least 1.25 or higher. This means the NOI must be at least 25% greater than the mortgage payment.
In other words, the loan amount is such that you will have positive cash flow equal to at least 25% of the mortgage payments. So, if you buy a property with a low capitalization rate, you will need a higher down payment to meet the lender’s DCR. For example, properties in California with a 5% cap often require a down payment of 50% or more.
To make matters more complicated, some lenders advertise a 1.25% DCR but cover the loan at an interest rate of 2%-3% higher than the note rate! Since the 2007 financial crisis, most commercial lenders have chosen to keep LTV at 70% or less. Higher LTV is possible for high-quality properties with strong national tenants, e.g.
Walgreens or in an area that the lender is very familiar with and comfortable with. However, you will rarely see an LTV higher than 75%. Commercial real estate is aimed at an elite group of investors so there is no such thing as 100% financing.
Interest Rate: Interest for commercial depends on various factors below:
Loan term: The interest rate is lower for a 5 year fixed rate which is shorter than for a 10 year fixed rate. It is very difficult to get a loan with a fixed rate of more than 10 years unless the property has a long term lease with a credit tenant, e.g. Walgreens. Most lenders offer 20-25 years amortization. Some credit unions use 30-year amortization. For single-tenant properties, lenders may use 10-15 years amortization.
Renter credit rating: The interest rate for drugstores occupied by Walgreens is much lower than for drugstores HyVee because Walgreens has a much stronger S&P rating.
Property type: Interest rates for a single-tenant nightclub building will be higher than for a multi-tenant retail strip because the risk is higher. When a nightclub building is foreclosed on, it is much more difficult to sell or rent it compared to a multi-tenant retail strip. Rates for apartments are lower than the shopping strip. For lenders, everyone needs a roof over their heads no matter what, so the rates are lower for apartments.
Property age: Loans for newer properties will have lower rates than dilapidated ones. For lenders, the risk factor for older properties is higher, so the rates are higher.
Area: If the property is located in a growing area such as a Dallas suburb, the rates will be lower than similar properties located in a declining rural area of Arkansas. This is another reason you should study the demographic data of the area before you make a decision
Loan amount: In a residential mortgage, if you borrow less money, i.e. a suitable loan, your interest rate will be the lowest. When you borrow more money, i.e. jumbo or super jumbo loans, your rates will be higher. In commercial mortgages, the opposite is true! If you borrow a $200K loan your rate could be 8%. But if you borrow $3M, your rate is only 4.5%! In a sense, it’s like getting a lower price when you buy an item in bulk at Costco.
The lender from which you apply for the loan. Each lender has its own rate. There may be significant differences in interest rates. Hard money lenders often have the highest interest rates. So you should work with someone who specializes in commercial loans to shop for the lowest rates.
Prepayment flexibility: If you want to have the flexibility to pay the loan in advance, then you will have to pay a higher rate. If you agree to keep the loan for the term of the loan, the rate is lower.
Commercial loans are exempt from various consumer laws aimed at housing loans. Some lenders use the “360/365” rule in calculating mortgage interest. Under this rule, the interest rate is based on 360 days a year. However, interest payments are based on 365 days of the year. In other words, you have to pay an additional 5 days of interest (6 days in a leap year) per year. As a result, your actual interest payments are higher than the rate stated in the loan documents because the effective interest rate is higher.
Prepayment Penalty: In housing loans, the prepayment penalty is often an option. If you don’t want it, you pay a higher rate. Most commercial loans have a prepayment penalty. The amount of the prepayment penalty is reduced or decreased every year. For example, on a loan with a fixed interest rate of 5 years, the prepayment penalty for the first year is 5% of the balance. This is reduced to 4% and then 3%, 2%, 1% for the 2nd, 3rd, 4th and 5th years.
For channel loans, the prepayment amount is very large because you have to pay interest between the note rate and the equivalent US Treasure rate on the entire loan balance for the remaining term of the loan. This prepayment penalty is called defeasance or yield maintenance.
Borrowing Fees: In residential mortgages, lenders may offer a “no points, no fees” option if you pay a higher rate. Such options are not available in commercial mortgages. You will have to pay between up to 1 point loan fee, assessment fee, environmental assessment report fee, and processing/guarantee fee. Lenders usually issue a Letter of Interest (LOI) to borrowers if they are interested in lending you money.
The LOI states the loan amount, interest rate, loan terms and fees. After the borrower pays approximately $5000 in loan application fees for third-party reports (assessment, phase I, survey), the lender begins to cover the loan. He ordered his own assessment using a pre-approved MAI (Member of the Appraisal Institution) appraiser. If the lender approves the loan and you don’t accept it, then the lender keeps all costs.
Types of Loans: While there are different types of commercial loans, most investors often find 3 main types of commercial loans:
1. Small Business Administration or SBA loan. This is a government-guaranteed loan intended for the property the owner uses. When you occupy 51% or more of the space in a building (gas stations or hotels are considered owner-occupied property), you qualify for the program. The main benefit is that you can borrow up to 90% of the purchase price.
2. Portfolio loans. This is a type of commercial loan where the lender uses their own money and keeps it on the balance sheet until maturity. Lenders are often more flexible because it’s their money. For example East West Bank, US Bank and some life insurance companies are portfolio lenders. These lenders require borrowers to provide personal guarantees for loan repayments. And thus this loan is a recourse loan.
3. Conduit loans or CMBS (Commercial Mortgage-Backed Securities) loans. This was a very popular commercial lending program before the 2007 recession where its market size was over $225 Billion in 2007. It dropped to just a few Billion in 2009 and came back again with the issuance of nearly $100 Billion in 2015. Many individual loans of this size different, on location
The rates are often lower. It is often around 1.2% over the 5 or 10 year US Treasury rate compared to 1.85-3% over the 5 or 10 year US Treasury rate for portfolio loans. Some CMBS loans only have interest payments. Because the rates are lower and the borrower is required to pay interest only, the LTV can be more than 75%. Low interest rates and high LTV are the main advantages of channel loans.
Channel lenders only consider large loan amounts, e.g. at least $2 million.
The lender requires the borrower to form a single asset entity, e.g. Limited Liability Company (LLC) to take rights to the property. It is intended to protect the property from other obligations of the borrower.
The loan is non-recourse which means the property is the only guarantee for the loan and the borrower does not have to sign a personal guarantee. So these loans are popular among investment companies, REITs (Real Estate Investment Trusts), TIC (Joint Tenants) companies that invest in commercial real estate using funds raised from various investors.
If the borrower then wishes to sell the property before the loan is due, the new buyer must cover the loan because the seller is unable to repay the loan. This makes it difficult to sell the property because the buyer must obtain a large amount of cash for the difference between the purchase price and the loan balance. Furthermore, lenders/lenders may refuse loan assumption applications for various reasons because there is no strong incentive for it.
Lenders may also impose new requirements for approval of loan assumptions, e.g. increase the reserve amount by several hundred thousand dollars. If you are a 1031-stock buyer, you may want to think twice about buying a property assuming a loan. If the lender rejects your loan assumption application, you may not qualify for a 1031 exchange and be liable to pay capital gains. This is the hidden cost of channel lending.
Even when you are allowed to prepay a loan, it costs money if you want to prepay the loan. The prepayment penalty is often called Defeasance or Yield Maintenance. You basically have to pay the difference in interest between the rate on your note and the applicable US Treasury rate for the remaining years of the loan! This amount is often so high that the seller usually asks the buyer to take out a loan. You can calculate defeasance from the website www.defeasewithease.com. In addition to deeasance, you also have to pay a 1% loan assumption fee. This is another hidden cost of channel lending.
A conduit loan may be a loan for you if you intend to keep the loan for the term of the loan that you agreed to at the beginning. Otherwise, it can be very expensive due to its inflexibility.
Lenders Coverage Areas: Commercial lenders will do business in areas they are familiar with or have local offices. For example, the East West Bank will only consider properties in California. Many commercial lenders do not provide loans to overseas investors.
Types of Property Lenders Cover: Most commercial lenders will only consider certain types of property they are familiar with. For example, Chase will work on apartments and office buildings that are owner-occupied but not retail properties or gas stations. Westford Financial specializes in church financing. Comerica concentrates on owner-occupied properties.
Lender Escrow Account: Most lenders require borrowers to pay 1/12 property tax each month. Some lenders require borrowers to have a repair and/or TI (Tenant Upgrade) reserve account to ensure the borrower has sufficient funds to cover major repairs or lease costs if the existing tenant does not renew the lease.
Conclusion: Commercial loans are much more complex and difficult to obtain with more unexpected loan approvals than housing loans. As an investor, it is in your best interest to hire a professional commercial loan broker to assist with your commercial loan needs. By doing so, you will greatly increase your chances of paying lower interest rates, avoiding potential pitfalls and increasing your chances of getting an approved loan.