Commercial lending is whole world separate from residential mortgages. Commercial properties are intended to be income-producing, leading to a multitude of factors to be considered by commercial lenders. This brief guide describes commercial lending and offers tips on how to find the best commercial mortgage for your investment.
Players in Commercial Lending
Banks and independent lenders make loans on commercial real estate. Other players include insurance companies, pension funds, private investors, and programs like the U.S. Small Business Administration’s 504 Loan program. We will tackle some of these briefly below:
Banks – It may be harder to get a loan from this type because credit has to be really good. Banks tend to have less flexibility in their underwriting process. Some banks have expertise in specific sectors such as multi-family, retail, or industrial. Be sure to ask if they specialize in your sector!
Life Insurance Companies – Offering loans to the highest quality buyers with 10-30 years amortization, loan companies tend to go with the least risky projects.
Bond Market (CMBS) – CMBS, or commercial mortgage-backed securities are bonds tied to pieces of commercial real estate loans. CMBS lenders cut up loans against commercial properties so that they can be sold to investors. These loans are best for long-term, stable borrowing.
Debt Funds – Debt funds allow for investment in loans either by direct lending or buying the loans. Often used for construction loans, these loans tend to have higher return in exchange for higher risk. If you are a developer, this could be a good option for you!
Government-Sponsored Entities – No, these aren’t government-sponsored ghosts. GSEs enable direct lending institutions to originate low-cost loans on properties that meet specific financial criteria. GSEs assume the loans upon origination, so they are not actually direct lenders. GSEs are often used for multifamily properties to support housing affordability.
I couldn’t help myself..
Usually commercial real estate loans are made to business entities rather than an individual. Still not a ghost, so what’s the true name of said “entities?” They include corporations, developers, limited partnerships, trusts and funds.
The lender may see the entity as a ghost if it does not have a credit rating or financial history, so they will ask the principals of the entity to personally guarantee the loan. This way, the lender has physical people that they can get credit & financial history from, as well as go after if the entity defaults on the loan.
Now that we know who the players are, what are the rules of the game? We will run through terms and common practices that you should be familiar with as you navigate the commercial lending world.
Residential loans are repaid in regular installments over a period of time so that the loan is fully repaid at the end of the loan term.
Commercial loans, however, range from 5 to 20 years with an amortization period that is often longer than the term of the loan. This means that an investor will make payments for the loan term based off of the amortization period, then make a balloon payment at the end of that loan term for the remaining balance of the loan. Longer amortization periods help reduce payments, but can add to the overall interest the investor will have to pay.
The LTV, or loan-to-value ratio, is calculated by dividing the amount of the loan by the lesser of: the property’s appraised value or its purchase price. If the buyer puts down more money, their LTV will be lower. Lower LTVs qualify for better financing rates. From the lender’s standpoint, there is less risk if the buyer has more equity in the property. Commercial loan LTVs tend to be lower than residential because there is no private mortgage insurance for commercial lending to protect lenders from borrower default.
Debt-Service Coverage Ratio
This is the comparison of a property’s NOI (Net Operating Income) to its annual mortgage debt service (principal and interest) to measure the property’s ability to service its debt. Here is a math version of what we just said:
NOI ÷ Annual Debt Service = Debt-Service Ratio
A DSCR of less than 1 indicates that there is a negative cash flow. Commercial lenders are generally looking for at least 1.25 because there is adequate cash flow. What lenders look for can change based on the stability of the property’s cash flow. A 1.5 isn’t necessarily great if it is constantly fluctuating.
Commercial loans tend to have higher interest rates than residential loans, and there are fees associated with the overall cost of the loan. These fees include appraisal, legal, loan application, survey, and loan origination fees. Be sure to pay attention here — some fees are applied annually and you will want to negotiate or find the lowest fees.
How to Find the Best Commercial Lender
Now that you know the basics about commercial loans, it’s time to find the best commercial lender for your investment! Some questions to ask include:
Do they have the loan-to-value ratio limit that you need?
What are the rates and fees of the loan?
What types of commercial loans do they specialize in?
All in all, the goal is to look at the overall cost of the loan including rates and fees to compare and decide which loan suits you best. Still have questions? We are happy to help, and we can even get you in touch with commercial lenders in our area. 630.984.4701
Until next time,