Finding the Best Commercial Mortgage Loan
Finding the Best Commercial Mortgage Loan is in an entirely different category than residential lending. Commercial property loans are often vastly different than loans for residential properties. Although they both pertain to real property, and sometimes even income-producing property on the 1-4 unit residential side, commercial loans are simply more complicated than residential loans.
There are two main reasons commercial property loans are so different from residential property loans:
- The numerous types of commercial properties that exist
- The value of commercial property.
There are a wide variety of properties that would fall under the umbrella of commercial property loans, including office buildings, multifamily (5+ units) apartment buildings, warehouse and retail centers. Commercial properties can also consist of self-storage facilities, automotive, industrial and light industrial, hospitality (motel/hotel), mobile home parks, daycare centers, raw land and agricultural properties, churches and other special use properties.
The process of securing a commercial loan is vastly different that that for a primary residence or even a 1-4 unit investment property. Here is everything you need to know about how to obtain the best commercial loan to fit your needs.
A. What Are Commercial Mortgage Loans?
Finding the best commercial mortgage loan is a whole different ballgame than 1-4 unit residential mortgage lending.
The primary difference lies in the ways in which the properties are valued. Whereas traditional residential properties are generally valued based on a sales comparison approach, commercial properties are valued based on current and future income-producing potential. The income produced by a commercial property is the driving factor behind a commercial property lender’s funding decision.
Determining a commercial property’s qualifying income can be a difficult task, involving a detailed look at the property’s financial situation. Again, the types of commercial properties can vary widely-for example, they can range from apartment buildings, industrial warehouses, or retail strip malls-and therefore, underwriting a commercial loan can be as complicated as the financials of the underlying property.
In addition, of relevance to commercial loans are the financials of the business or businesses operating at the commercial property. At least in the owner-occupied context, because of the second key component of commercial loans-evaluating the strength of the borrower, also referred to as the transaction’s “sponsor.”
The options for ways to structure a commercial loan vary. Commercial mortgage loan terms are more expansive than available for 1-4 unit residential properties and can quickly become overwhelming even for savvy real estate investors.
B. Key Distinctions: Commercial vs. Residential Property Loans
Commercial loans are riskier and more complex than residential loans. Here are some of the key distinctions between residential and commercial property loans.
1) Underwriting – Evaluating Strength of Transaction
Commercial loans focus mostly on the current and future income-producing potential of a property (as opposed to focusing primarily on the income of the borrower on the residential side).
2) Down Payments & Loan-to-Value (LTV)
Commercial property lenders will generally approve a loan-to-value (“LTV”) that is less than what borrowers are accustomed to on the residential side, meaning higher down payments and lower leverages.
3) Commercial Loan Costs
Commercial loans will typically (although not always) come with higher rates, a higher down payment, and shorter terms (which will increase monthly payments). Interest rates and costs vary depending on the lender and LTV, Debt Service Coverage Ratio (DSCR), and After-Repair-Value (where applicable).
In addition, commercial loans often come with appraisal and environmental/toxic report costs, which can be significant.
4) Commercial Loan Terms & Prepayment Penalties
Commercial property loans have terms of generally 6-36 months for hard money commercial loans, and 5-20 years for permanent commercial loans. The best commercial mortgage hard money loans generally consist of interest-only payments, and permanent commercial loans often have an amortization schedule that is longer than the loan’s term. In both cases a balloon payment is due at the end of the loan’s term. Finding the best commercial mortgage loan in the hard money sector is not as hard as someone may think.
Since 2010, Dodd-Frank has prohibited prepayment penalties on owner-occupied loans in the residential 1-4 unit arena. But for commercial property loans, prepayment penalties are more common.
5) Identifying the Sponsor in a Commercial Loan
Commercial loans are often made to business entities, such as an LLC, corporation, partnership or trust, which is also called the “sponsor.” The sponsor is the entity or individual to whom the loan is made. If the sponsor is an entity, sometimes commercial property lenders will require an individual (or individuals) to guarantee the loan, called “guarantors.”
A personal guarantee means the guarantor is personally responsible to pay back the loan in the event of default, even if a business entity is the holder of the note. This is considered a recourse loan, which allows the lender to look to the personal assets to satisfy the loan in the event of default.
In a non-recourse loan, on the other hand, if the sponsor fails to make payments, the lender’s only remedy (recourse) is to take back the property and sell it.
C. Common Types of Commercial Property Loans
There are many types of commercial mortgage loans, which can be broadly grouped into four categories: (1) “Full Doc” Conventional Commercial Loans; (2) Stated Income & Bank Statement Commercial Loans; (3) Hard Money Commercial Loans; and (4) SBA (Small Business Association) Loans).
1) “Full Doc” Conventional Commercial Loans
Conventional commercial loans are offered by FDIC-insured institutions such as banks or credit unions. Any type of commercial property can qualify for a conventional loan.
These loans often have the best rates, but they are also among the hardest to qualify for. For starters, conventional lenders require global debt-to-income (DTI) ratio calculations for the sponsor and/or guarantor, as well as minimum debt service coverage ratio (DSCR) above 1.15 of even higher depending on the loan program.
These loans often require a personal guarantee, with business and personal tax returns requested from the sponsor and/or guarantor showing at least 2 years of profit history.
2) Stated Income & Bank Statement Commercial Loans
Bank statement and stated income commercial loans are outside of conventional commercial underwriting guidelines and are not repackaged and sold on the secondary securities market. Instead, they are held on lender’s portfolios, why they are sometimes called “portfolio loans.”
(a) Commercial Bank Statement Loans
Commercial bank statement loans contain a similar analysis as is used on the residential owner-occupied bank statement loan side. Instead of tax returns, the sponsoring entity can supply 12-24 bank statements showing sufficient cash flow to make payments on the requested commercial loan.
Commercial bank statement loans are an incredible financing vehicle for small business owners, whose tax returns often do not accurately reflect a sponsor’s true income or purchasing power, because many business owners take advantage of all available legal deductions.
(b) Commercial Stated Income Loans (P&L Only Loans)
As an additional alternative to using tax returns or bank statements to qualify for a commercial property loan, sponsors may take advantage of commercial stated income loans. Sometimes referred to as “P&L Only Loans”, in which income is simply stated using a CPA-prepared profit and loss statement.
Commercial stated income loans typically have slightly higher rates due to the increased risk lenders take on by dispensing with income verification requirements. The trade off for sponsors is that without this requirement, underwriting moves quicker, and commercial stated income loans can fund quicker than more traditional conventional commercial property loans.
3) Commercial Hard Money Loans
Every well-equipped borrower’s toolbox should have a reputable commercial hard money funding source. Conventional lenders have loan committees and a more involved underwriting process, both of which can delay the process and do not allow for the same flexibility commercial hard money loans can offer.
Commercial hard money loans are a great option when a quick close is needed, a property is not currently at its maximum income-producing potential, or the sponsor is unable or unwilling to produce tax returns and other financials.
(a) Speed – Same-as-Cash Purchasing Power
One of the main reasons to use commercial hard money loans is their speed. Hard money loans can be closed much quicker than conventional or other more traditional loans often in 2-3 weeks, sometimes quicker.
Some of the best commercial hard money lenders can make their underwriting decisions and issue a term sheet on the first phone call.
(b) Temporary Financing Needs – Value Adds & Property Stabilization
Properties that are at their full income-producing capacity are described as being “stabilized.” Most conventional and other traditional commercial property lenders require a property to be stabilized in order to fund a loan. Commercial hard money lenders, on the other hand, do not.
In addition, Commercial hard money lenders will lend funds to be used for renovation and/or stabilization and to mitigate the increased risk they charge higher interest rates and points than conventional commercial mortgage lenders.
Secondly, Commercial hard money lenders will set maximum loan amounts based on the anticipated stabilized value of a commercial property. The sponsor has to demonstrate a clear path to stabilization. For example, a commercial real estate investor might plan to purchase an underperforming strip mall with many vacancies. By doing a gut rehab and filling the finished units with tenants paying the new market rents for the property.
Finally, Commercial hard money lenders are willing to provide temporary financing in these situations based on increased return on investment coupled with a demonstrated viable exit strategy. Once the property has reached its full income-producing capacity, or becomes “stabilized,” the hard money loan can be paid off in one of two ways.
- Sell the property
- Refinanced the property once stabilized.
(c) Sponsor Financials Currently Less Than Perfect
Commercial hard money lenders are far less concerned with credit issues and across the board have less stringent underwriting guidelines.
There are times when a sponsor is simply unable to provide documentation traditional lenders require, whether due to the nature of their business, or the fact that tax returns may not be an accurate reflection of the current financial situation.
Hard money lenders are willing to look past credit issues within reason. This is possible if there is enough equity in the property or a borrower has enough cash reserves to service the debt.
4) SBA Commercial Mortgage Loans
The U.S. Small Business Administration provides guarantees for certain commercial property loans, through two loan programs: SBA 7a Commercial Loans, and SBA 524 Commercial Loans. These loans are available only for owner-occupied commercial properties. For example, hotels and self-storage facilities are eligible, while apartment buildings are not.
SBA Loans can often be used to purchase not only land and existing structures, but also to make lot improvements, renovate, or even construct new facilities.
The benefits of SBA Commercial loans include reduced down payment requirements and serving businesses in underserved markets. Sponsors can finance up to 90% of the property cost, plus improvements.
While SBA commercial loans often offer competitive and even below market rates and terms, they involve a lengthy approval process that can take up to 120 days or longer. Owners that do not have a lot of liquidity for a large down payment would look for this type of loan.
5) Other Commercial Mortgage Loans
There are as many different types of commercial property loans, and are as unique as the many various types of commercial properties. A few of the more commonly seen commercial loans include:
Freddie Mac Multifamily Loans. These are available for loan amounts above $1,000,000, and for properties in large metropolitan areas. Freddie Mac Multifamily Loans offer competitive rates and also incentives to provide affordable income housing.
Life Company Loans. These loans are for well-qualified borrowers, and high-quality stabilized properties are preferred, although construction and development projects are considered. Life company loans are made by life insurance companies or groups of life insurance companies and are generally the most conservative of all commercial property loans.
CMBS Loans. Commercial Backed Security Loans (“CMBS Loans”) are non-recourse loans that are pooled together and securitized by offering bonds collateralized by the financed properties. These do not require tax returns or global cash flow analysis.
D. Commercial Property Loan Underwriting
Commercial mortgage loans focus on two primary categories:
- Financial picture of the property (and sometimes also the operating business(es))
- Financial picture of the sponsor or sponsoring entity or entities.
1) Commercial Property Financials – How to Value Commercial Property
A commercial property’s potential income production will determine their value. Stabilized properties are properties that are income producing at their highest and best use.
The relevant income here is the property’s net income (as opposed to gross income). The net operating income (“NOI”) of a commercial property is the amount equal to its total revenue minus operating expenses.
(a) NOI (Net Operating Income)
The total amount of revenue of a property less its operating expenses is the net operating income (NOI).
The property’s rent roll determines the NOI of the property. The rent roll will include info such as which units are occupied and for what amounts, lease dates and terms, security deposit info, and other fees collected from tenants (parking, laundry, etc.), and provides a good idea of the economic situation of a property.
(b) DSCR (Debt Service Coverage Ratio)
The Debt Service Coverage Ratio, or DSCR, is a measure designed to help lenders determine a sponsor’s ability to repay. Essentially, it measures the current cash flow’s ability to pay the current debt obligations.
The DSCR ratio compares a property’s net operating income (NOI) to the annual loan payment. To calculate DSCR, simply divide the NOI by the annual debt service. For instance, if your NOI is $300,000 and annual loan payments are $175,000, the DSCR = 1.71 ($300,000 NOI / $175,000 Debt Service).
A DSCR greater than 1.00 means indicates positive cash flow, meaning the NOI is sufficient to meet all debt obligations (negative DSCR indicates negative cash flow). The higher the DSCR, the better the investment.
Because commercial properties are so much more complex than residential properties, commercial appraisals typically take 2-3 weeks to complete. This is because appraisers must consider several variables in determining a property’s value.
Commercial appraisals are also more expensive than residential appraisals and can easily range between $2,500 and $4,000 due to the complexity of the document, the length, and how long it takes to complete. Commercial appraisals are much more detailed than residential appraisals.
2) Commercial Property Sponsor
While commercial loan underwriting does focus on the income performance of the property. The financials of the borrower and/or borrowing entity still have some relevance in the equation.
Commercial property loans are often made to business entities, such as an LLC, corporation, or trust, etc., called the “sponsor”. Guarantors are individuals who personally guarantee a loan.
Similar to residential mortgage transactions in which lenders review the following:
- Personal credit
- Income of a borrower
- Sponsor’s income
- Credit history
They use these and more to form a basis of a commercial property lender’s funding decision. To demonstrate an ability to make payments, Sponsors are generally required to have good credit, significant net worth and liquidity.
E. Applying For Commercial Property Mortgage Loans
Commercial lenders and their loan programs vary as widely. The process of securing a commercial loan is a vastly different process than that for a residential loan. Borrowers should consider many possible factors in applying for a loan, including loan features, pertinent tax considerations and economic conditions.
The commercial loan application and underwriting process is longer and more involved than for residential loans. Commercial lenders are more interested in getting to know the financials of sponsoring entity to feel more comfortable in extending funds. The more relevant financials that can be provided in a commercial loan transaction, the more favorable the terms.
F. Finding The Right Commercial Property Lender
Commercial property loans are more complicated and lengthier than residential loans. Many commercial property sponsors and borrowers are not experts in commercial property financing. Commercial mortgage professionals not only procure funding sources, but also act as advisors. With the ability to match borrowers with lenders because they know what the market will support.
With so many different commercial loan options, it is important to shop around and get the best deal. It is best to work with a broker who has knowledge of and access to all available loan programs. Commercial mortgage brokers will assist every step of the way to submit loan applications with the best likelihood of success.
Commercial property loans are a great way for investors and business owners to expand their profit-making potential. With so many great options and terms to choose from, it is important to conduct proper due diligence. Find the best commercial property loan and best lender for your needs.
G. Bottom Line Of Mortgage Loans
There is no doubt commercial property lending is more complex than traditional residential property financing.
Gregory Riggs Esq.