Your commercial real estate transaction only ends if the loan is approved. You can also improve the cash flow if the loan interest rate is low. So, the more you know about commercial loans, the better the decision you can make regarding your commercial real estate investment.
Loan Eligibility: Most of you have applied for a home loan and are familiar with the process. You provide the lender with:
- W2’s and/or tax returns so it can verify your income,
- Bank and/or brokerage statements so it can verify your liquid assets and down payment.
In general, the higher the personal income, the larger the loan amount. You could even borrow 95% of the purchase price for a one-unit primary residence with sufficient income.
For commercial loans, the loan amount a lender will approve is based primarily on the property’s net operating income (RDA), not your personal income. This is the fundamental difference between qualifying as a residential and commercial loan. Therefore, if you buy a vacant commercial building, you will have a hard time getting the loan approved because the property has no rental income. However, if you
- Occupy at least 51% of the space for your business; you can apply for SBA loan.
- Have sufficient income from another commercial property used as cross collateral; there are lenders out there that want your business.
Loan to Value: Commercial lenders tend to be more cautious when it comes to loan to value (LTV). Lenders will only lend you the amount such as the ratio of NOI to a mortgage payment for the loan called the Debt Coverage Ratio (DCR) or Debt Service Ratio (DSR) must be at least 1, 25 or more. This means that the NOI must be at least 25% higher than the mortgage payment. In other words, the loan amount is such that you will have a positive cash flow equal to at least 25% of the mortgage payment. So, if you are buying a property with a low cap rate, you will need a larger 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 complicate matters, some lenders advertise 1.25% DCR but take out the loan with an interest rate 2% -3% higher than the note rate! Since the financial crisis of 2007, most commercial lenders prefer to keep the LTV at 70% or less. Higher LTV is possible for high quality properties with strong national tenants eg. Walgreens or in areas with which lenders are very familiar and comfortable. However, you will rarely see more than 75% LTV. Commercial real estate is for the elite group of investors, so there is no 100% financing.
Interest rate: The interest for the commercial depends on various factors below:
- Loan term: The rate is lower for the shorter 5 years fixed rate than the 10 years fixed rate. It’s very hard to get a loan with fixed rate longer 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 years amortization. For single-tenant properties, lenders may use 10-15 years amortization.
- Tenant credit rating: The interest rate for a drugstore occupied by Walgreens is much lower than one with HyVee Drugstore since Walgreens has a much stronger S&P rating.
- Property type: The interest rate for a single tenant night club building will be higher than multi-tenant retail strip because the risk is higher. When the night club building is foreclosed, it’s much harder to sell or rent it compared to the multi-tenant retail strip. The rate for apartment is lower than shopping strip. To the lenders, everyone needs a roof over their head no matter what, so the rate is lower for apartments.
- Age of the property: Loan for newer property will have lower rate than dilapidated one. To the lender the risk factor for older properties is higher, so the rate is higher.
- Area: If the property is located in a growing area like Dallas suburbs, the rate would be lower than a similar property located in the rural declining area of Arkansas. This is another reason you should study demographic data of the area before you buy the property.
- Your credit history: Similarly to residential loan, if you have good credit history, your rate is lower.
- Loan amount: In residential mortgage, if you borrow less money, i.e. a conforming loan, your interest rate will be the lowest. When you borrow more money, i.e. a jumbo or super jumbo loan, your rate will be higher. In commercial mortgage, the reverse is true! If you borrow $200K loan your rate could be 8%. But if you borrow $3M, your rate could be only 4.5%! In a sense, it’s like getting a lower price when you buy an item in large volume at Costco.
- The lenders you apply the loan with. Each lender has its own rates. There could be a significant difference in the interest rates. Hard money lenders often have highest interest rates. So you should work with someone specialized on commercial loans to shop for the lowest rates.
- Prepayment flexibility: If you want to have the flexibility to prepay the loan then you will have to pay a higher rate. If you agree to keep the loan for the term of the loan, then the rate is lower.
Commercial loans are exempt from various consumer laws aimed at residential lending. Some lenders use the “360/365” rule to calculate mortgage interest. With this rule, the interest rate is based on 360 days per year. However, the interest payment is based on 365 days a year. In other words, you have to pay an additional 5 days (6 days in a leap year) of interest per year. As a result, your actual interest payment is higher than the rate stated in the loan documents because the effective interest rate is higher.
Prepayment Penalty: In the case of a home loan, a prepayment penalty is often an option. If you don’t want it, you pay a higher rate. Most business loans have prepayment penalties. The amount of the prepayment penalty is reduced or reduced each year. For example on a 5 year fixed rate loan, the prepayment penalty for the first year is 5% of the balance. It is reduced to 4% then to 3%, 2%, 1% respectively for the 2nd, 3rd, 4th and 5th year. For intermediate loans, the prepayment amount is huge because you have to pay the interest between the note rate and the equivalent US Treasury rate for the total loan balance for the remaining term of the loan. This prepayment penalty is called defeasance or yield maintenance.
Loan Charges: With a residential mortgage, lenders may offer you a “no points, no charge” option if you pay a higher rate. Such an option is not available in commercial mortgage. You will need to pay between ½ to 1 point of loan fees, appraisal fees, EA report fees, and processing / subscription fees. A lender normally issues a letter of interest (LOI) to the borrower if they are interested in lending you money. The letter of intent indicates the loan amount, interest rate, loan term and fees. After the borrower has paid around $ 5,000 for the loan application fee for third party reports (appraisal, phase I, investigation), the lender begins to take out the loan. It orders its own assessment using its own pre-approved MAI (Member of Appraisal Institute) assessors. If the lender approves the loan and you don’t, the lender keeps all costs.
Types of Loans: Although there are different types of business loans, most investors often come across 3 main types of business loans:
1. Small business administration or SBA loan. This is a government guaranteed loan for owner occupied properties. When you occupy 51% or more of the space in the building (gas station or hotel is considered owner-occupied property), you qualify for this program. The main advantage is that you can borrow up to 90% of the purchase price.
2. Portfolio loan. This is the type of business loan in which lenders use their own money and keep their balance sheets until maturity. Lenders are often more flexible because it’s their money. For example, the East West Bank, the American Bank, and some life insurance companies are portfolio lenders. These lenders require borrowers to provide personal collateral for the payment of the loans. And so these loans are recourse loans.
3. Conducted loan or CMBS (Commercial Mortgage-Backed Securities) loan. This was a very popular commercial loan program before the 2007 recession, when its market size exceeded $ 225 billion in 2007. It was down to a few billion in 2009 and returns with the issuance. nearly $ 100 billion in 2015. Many individual loans of different sizes, in different locations, are grouped together, rated from Triple-A (Investment grade) to B (Junk), then sold to investors around the world under form of bonds. It is therefore not possible to prepay the loan because it is already part of an obligation. Here are the characteristics of intermediary loans:
- The rate is often lower. It is often around 1.2% over the 5 or 10 year US Treasury rates compared to 1.85-3% over the 5 or 10 year US Treasury rates for portfolio loan. Some CMBS loans have interest only payments. Since the rate is lower and borrowers are required to pay interest only, the LTV can be over 75%. Low rates and high LTV are the key advantage of conduit loan.
- Conduit lenders only consider big loan amount, e.g. at least $2M.
- Lenders require borrower to form a single-asset entity, e.g. Limited Liability Company (LLC) to take title to the property. This is intended to shield the property from other the borrower’s liabilities.
- The loans are non-recourse which means the property is the only collateral for the loan and the borrowers do not have to sign personal guaranty. And so these loans are popular among investment firms, REIT (Real Estate Investment Trust), TIC (Tenants in Common) companies that invest in commercial real estate using funds pooled from various investors.
- If the borrower later wants to sell the property before the loan matures, the new buyer must assume the loan as the seller cannot pay off the loan. This makes it harder to sell the property because the buyer needs to come up with a significant amount of cash for the difference between the purchase price and loan balance. Furthermore, the lender/loan servicer could reject the loan assumption application for various reasons as there are no strong incentives for it to do so. The loan servicer can also impose new conditions to loan assumption approval, e.g. increase reserve amount by several hundred thousand dollars. If you are a 1031-exchange buyer, you may want to think twice about buying a property with loan assumptions. Should the lender reject your loan assumption application, you may end up not qualifying for the 1031 exchange and be liable for paying capital gain. This is the hidden cost of conduit loan.
- Even when you are allowed to prepay the loan, it costs an arm and a leg if you want to prepay the loan. The prepayment penalty is often called Defeasance or Yield Maintenance. Basically you have to pay the difference in interest between the note rate of your loan and the applicable US Treasury rate for the remaining years of the loan! This amount is often so high that the seller normally requires the buyer to assume the loan. You can compute the defeasance from www.defeasewithease.com website. Besides the defeasance, you also have to pay 1% loan assumption fee. This is another hidden cost of conduit loan.
The lead loan may be the right loan for you if you intend to hold it for the duration of the loan you initially accepted. Otherwise, it could be very expensive due to its gain rigidity.
Lender Coverage Area: Commercial lenders would do business in areas they are familiar with or have local offices. For example, the eastern West Bank will only consider properties in California. Many commercial lenders do not lend to foreign investors.
Lender Coverage Types of Property: Most commercial lenders would only consider certain types of properties that they are familiar with. For example, Chase would make owner-occupied apartments and office buildings, but not commercial buildings or gas stations. Westford Financial specializes in financing churches. Comerica focuses on owner occupied properties.
Lender Escrow Accounts: Most lenders require borrowers to pay 1/12 property taxes each month. Some lenders require borrowers to have repairs and / or a Tenants Improvement (TI) reserve account to ensure borrowers have sufficient funds to cover major repairs or rental costs if existing tenants do not renew them. leases.
Bottom Line: Commercial loans are much more complex and difficult to obtain with more unpredictable loan approvals than residential loans. As an investor, it is in your best interest to employ a professional commercial loan broker to meet your commercial loan needs. Doing so will dramatically improve your chances of paying lower interest rates, avoid potential pitfalls, and increase your chances of getting loan approval.
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