Commercial real estate investing can be highly lucrative, but it’s not for the faint of heart. Commercial real estate is much more complex than buying a single-family home. For example, the due diligence process is much more robust. Financing is also handled differently than if you were just buying a single-family home.
Most people buy single-family properties using a traditional 30-year fixed-rate mortgage. The terms on these loans are usually fantastic, particularly for those who have good credit. Buyers take comfort in knowing they’ve locked in a long-term rate, thereby offering predictability with each mortgage payment, month after month, year after year.
Commercial real estate financing is much more diverse. There are many options available to investors depending on their needs: acquisition, construction, refinancing and more. In this article, we at Trion Properties will take a look at the factors that will affect your financing options and the different loan products available in the marketplace today.
What Factors Affect My Financing Options?
When purchasing a single-family home, a lender will typically look at a few simple factors, such as a person’s income, credit score, and credit history. It’s relatively straightforward. Buying commercial real estate is different in that lenders look at a variety of factors which will all influence your financing options. Those factors include:
When lenders look at a borrower’s creditworthiness, they don’t evaluate credit the same way that lenders would if you were taking out a residential loan. In other words, they aren’t looking at your FICO score as a leading indicator of creditworthiness. That’s because the larger your portfolio, the more likely you’ll have had some dings on your credit over time (which includes your total debt load).
Instead, lenders will look at your credit score in the context of other credit risk factors, such as your track record with repayment, your reputation (either the lender knows of you in the market or they don’t), your relationship with the bank (if you’re new the bank, they might want 2-3 bank references), and your overall financial wherewithal, which includes your personal finances, your company’s finances, your ability to access capital (debt and/or equity), and the quality of your existing real estate portfolio (including liquidity and ability to leverage if need be).
There are two ways to think of collateral. Technically, the term “collateral” refers to the specific property that is secured by the loan. When used in this context, collateral is referring to merits of the deal itself – in other words, what is the quality of the asset to which the lender is affixing a loan? In the event of default, is it a piece of collateral that lender will want to own?
Let’s say a property is in a great location, in great condition, has strong cash flow, and the borrower is putting a lot of equity into the deal. This is a great piece of collateral. A lender will be more likely to extend credit, and credit at favorable terms, to a borrower with high quality collateral than one that seems to be potentially higher risk.
The second way to think of collateral is in terms of the borrower’s portfolio that could be liquidated or leveraged to repay the loan if need be. Borrowers with large, liquid, and high-quality existing portfolios will have an easier time getting a commercial real estate loan than someone who does not.
Commercial real estate experience is also critically important for those seeking financing. Borrowers have many more financing options if they have a proven track-record in the industry. They’ll have more types of debt available to them, across debt categories, with multiple players chomping at the bit to extend credit with good terms.
Let’s say someone has no experience and wants to buy their first 50-unit apartment building. It’s not impossible to do, but they’ll have fewer options and will typically have more “substituting” factors – such as having to have a larger personal guarantee and/or a higher quality guarantee (meaning the borrower might have to partner with someone who has more industry experience).
There are ways to mitigate a lack of experience. You’ll have to provide something to a lender that gets them comfortable with the fact that you don’t have experience, such as putting more equity into the deal, or showing the bank that you have strong third-party partners such as a highly-experienced general contractor and property manager.
Absent experience, a borrower should expect to pay an above-average interest rate with lower leverage and personal guarantees on their first few deals until they have a track-record to make a bank feel more comfortable.
How Does Property Type Affect Loans?
The property type can determine what types of loans are available to you. Not all types of loans are available to all property types. Multifamily, for example, has a whole category of debt that is simply not available to office, industrial, retail and other loan types. This category, known as agency loan programs (i.e. Fannie and Freddie, CMBS), is something we’ll get into in more detail below.
There are unique characteristics of each property type that make certain types of financing and/or specific lenders more prone (or unlikely) to finance those property types. Some may have a fear of certain property types whereas other may have a niche in it.
Property class also affects the type of financing you can get. Class A properties will have more financing options (see collateral above) – better physical quality, better location, the more resilient leasing is perceived to be, the more debt available and at better terms. As you’d expect, financing terms get increasingly better as you move from Class C to Class B to Class A properties.
That’s one of the reasons why certain government loan programs exist. Agency loans, for example, are generally targeted to borrowers of Class C property types or owners of properties in markets where lenders otherwise typically wouldn’t go. More on this below.
Types of Commercial Property Loans
Bank loans are the most commonly used financing tool for those in commercial real estate. A bank loan is usually the most flexible and customizable loan product compared to other sources of CRE debt.
Typically, smaller banks will have hyper-local decision-making, meaning they can be more flexible because they understand the nuances of the local market. However, small, local banks can only lend so much. This is where the larger banks come into play.
When you’re working on large commercial real estate deals, you’ll typically want to go to a national bank. You’ll want to explore financing options with institutions like JP Morgan, Wells Fargo, and Bank of America.
Each geography and market is very different with the banks that operate there, how well capitalized they are, how aggressive they’ll get. Boston, for example, is considered “over-banked” – you can go out and get great rates just by shopping deals around a bit. That’s not the case in every market.
Life Insurance Companies
Life insurance companies will typically provide low-leverage loans on properties that have very stable cash flows, and typically will have the lowest interest rates for those who qualify. Life insurance companies prefer extremely low-risk loans, which is why they’re willing to extend the lowest interest rates on these deals.
The downside to utilizing a life insurance company loan is that they usually are less flexible than bank loans and very low leverage. Moreover, most life insurance companies only look to do larger loans ($20+ million), though there are certainly exceptions.
Government-sponsored enterprises, collectively referred to as agency lenders or GSE’s include Fannie Mae and Freddie Mac. These are government loan programs that were specifically created to finance multifamily with the mission of making sure the American population has abundant and affordable rental housing.
The way these programs work is that they create certain standards for their loans. If you meet those standards, you are guaranteed a loan – it is packaged up and sold as bonds to investors. Because they’ve been signed off on by Fannie Mae and Freddie Mac, they have more credibility with an “implied guarantee,” which is that if the underlying collateral goes bad or the payments stop, the U.S. government will step in and pay the debt on the bonds.
Commercial mortgage-backed security (CMBS) loans are structured through a conduit, usually a large bank, which will go out and make loans, then package them up and sell them off to the public as bonds.
CMBS loans can be used for all property types, not just multifamily as is the case with agency loans. The primary difference between CMBS loans and those offered by banks or life companies is that CMBS loans tend to be longer-term loans on properties with stable cash flows. There’s less need to have an active lender.
The big knock on CMBS loans is that when something comes up, good or bad, it can be difficult to have any flexibility. You’ll often have trouble tracking down a decision-maker who can modify the loan to better address your needs. Given the onerous nature of CMBS loans, these are usually lower down the list of options for most CRE borrowers. Deals with high-quality sponsors and high-quality assets will typically be snatched up by a traditional bank lender of life company before they make their way into a packaged CMBS loan. CMBS loans are more heavily utilized in markets that banks and life companies are less excited about, such as secondary and tertiary markets.
A commercial real estate debt fund is a pool of private equity-backed capital that has a mandate or specific target to originate collateralized real estate loans for qualified borrowers. For example, a commercial real estate company (such as MesaWest, CrossHarbor or CIM) might have a niche in a specific product type, say – multifamily housing. If the product type is one they’re familiar with, the debt fund will feel comfortable with a higher-risk deal because, worst case, if a borrower defaults on the loan, the originator of the debt fund will be able to step in and take over the property.
The interest rates tend to be higher than market average when utilizing a debt fund. These loans also tend to be short term, usually no more than three years with an option to extend. This gives the borrower enough time to stabilize a property or put permanent financing on it with a traditional lender, life insurance company, or CMBS loan. Loans from debt funds are usually non-recourse.
The U.S. Small Business Administration (SBA) has two distinct loan programs that can be utilized to finance commercial real estate.
- SBA 7A loans: These loans are backed by the SBA, and therefore, help a borrower increase their creditworthiness. 7A loans, like agency loans, reduce risk by giving some level of certainty that the loan will be repaid by the government agency. 7A loans are usually used for small deals. They can be arranged quickly and easily, but in exchange, often come with higher interest rates than SBA’s 504 loan program.
- SBA 504 loans: 504 loans are typically used for larger projects in which the loan totals $1 million or more. The borrower must have at least 10% equity in the deal. SBA will then lend up to 40%, with the balance of the loan issued by a more traditional lender.
SBA loans can only be used for owner-occupied commercial real estate (i.e., you’re buying the property that you plan to operate your business out of) and some hotel deals. They cannot be used for multifamily properties.
In recent years, there has been an explosion of online marketplaces intended to match borrowers with lenders interested in financing commercial real estate deals. Some of these online platforms are match-making entities only. Others are crowdfunding platforms that pool private funds online, similar to how a debt fund would pool capital. The difference is that crowdfunded debt funds will often have a lower minimum requirement and attract capital from a much more diverse group of investors.
What Banks Offer CRE Financing?
Almost every bank will offer some sort of commercial real estate loan product. Small community banks will typically have lower maximum loan amounts, say $10 or $20 million. Larger national banks, such as Wells Fargo, JPMorgan Chase, TD Bank and Bank of America, will typically do more substantial loans totaling tens, even hundreds of millions of dollars.
In some cases, if a loan amount is particularly substantial (say, $250 million), one bank may approach other banks to go in on the deal together. This way, each bank is sharing the risk instead of taking on the full loan amount themselves.
Depending on the bank, lending might be specialized. For example, some banks specialize in certain product types, such as multifamily housing or office development. Others will lend to borrowers with any product type as long as they are located within a specific geography.
Should I Use a Hard Money Lender?
Hard money lenders are private lenders that tend to extend loans on a short-term basis at a higher interest rate. These are most frequently used on small deals with non-institutional quality real estate or small construction projects. These loans tend to be utilized in short-term situations where someone needs to move quickly. For example, in a hot market, a developer may use a hard money lender to acquire a property and will seek to refinance into a more traditional, permanent loan.
It is important to understand that a hard money loan comes at a much higher interest rate with much higher fees than the other commercial real estate financing options discussed here today. The rate may be a full 3% to 5% higher than the average interest rate and may carry anywhere from a 2-4% fee going in and a 2-4% exit fee upon sale or refinance.
Most people will only use a hard money lender as a lender of last resort, and only if they are highly confident that they can execute on their real estate business plan to add value, reposition the property and refinance into a traditional loan, or entitle the site and flip for a profit.
How Can I Get a Commercial Property Loan?
There are a few ways to obtain a commercial property loan. It usually depends on what type of loan you want, for what type of project and product type, and your preexisting relationships.
Someone who’s been in the industry for years might already have strong banking relationships, in which case they’d go directly to those banks for a traditional loan. Those with less experience, or who don’t have strong pre-existing banking relationships, may instead work with a commercial real estate debt broker. There are several companies that specialize in arranging debt for clients. These brokers will canvass the market and find their customers the best terms for their deal and specific circumstances.
Some loan types are only available through an intermediary, such as a commercial debt broker. GSEs, for instance, have outsourced the origination and underwriting process for agency loans to pre-vetted partners. You have to work with one of the GSE’s pre-approved lenders (known as “DUS” lenders) to obtain agency financing.
CMBS loans can either be obtained directly from a large bank like Wells Fargo or JP Morgan (the big banks all have CMBS operations) or through a more boutique CMBS lender.
Can I Get a Loan with No Money Down?
It is rare that an investor will be able to get a commercial real estate loan with no money down. There are some extreme circumstances where aspects of the deal merit a no down payment loan, but these situations are very rare.
For example, 100% financing might be used in a situation where a real estate developer/investor has a relationship with the head of real estate for a local university. The investor learns, through his friend, that the university is looking to sign a 30-year lease for a private dorm. So the investor finds a site, let’s say – a vacant car dealership – and puts it under contract. He purchases the vacant car dealership for $3 million and then permits the site to be a private student housing building. As soon as he signs a long-term lease with the university, the property automatically skyrockets in value. The investor has essentially created value out of thin area. In this case, a bank might be willing to extend a loan with no money down given the unique circumstances.
However, it is important to understand that loans with no money down remain incredibly rare. There must be a reason for the deal to merit no down payment. This is even true with hard money lenders, which are often the most aggressive lenders in the marketplace.
Commercial real estate financing is one of the most critical components of any commercial real estate deal. The nature of these deals, which tend to be much larger or more expensive than a typical residential sale, require most investors to use debt to purchase, build or renovate the property.
Commercial real estate financing tools are as diverse as the industry itself. There are many financing options available to investors depending on the property type, location, and purpose of the loan.
It’s important for any prospective commercial real estate investor to understand the breadth of financing options available to them. Commercial loans can be structured very differently, and each loan can be tailored differently with unique terms to meet a customer’s needs. Building a relationship with your lender (or alternatively, a commercial debt broker) can go a long way for investors looking to lock in the best terms for their project.